The EU Breaking Up Is Not So Far Fetched As It Once Was

Over the last few weeks,  we have been noticing that Europe is ever becoming more reluctant to fix the structural problems of their sovereign debt crisis. All Europe has been doing is putting band aids over a infection that has now turned into septicemia with no political will to come up with a cure. Reports have come to light that Germany has threatened to the leave the EU and most recently, Germany is refusing to expand the $750 billion bailout package.  Bond yields on European debt slowly grind upward as US rating agencies continue to downgrade the  credit worthiness of European countries. Debt levels among European countries has exploded, with some debt to GDP ratio levels at 125%. All the while, countries such as France and Germany have to borrow more to fund the bailouts of the smaller countries who buried themselves in debt. It is our opinion at FXIB that this is only transferring the debt crisis from one country to another country and forestalling the inevitable.

Structural Problems

The EU has a monetary union but lacks the fiscal union necessary to contain the debt crisis. The fundamental problem is that each European country issues its own bonds and has their own fiscal policy, but not able to devalue the currency.  This leaves them susceptible  to bond vigilantes and in a precarious position. European countries are now tasked with having to produce balance budgets, but not at the expense of hurting their economy and all the while maintaining  massive social welfare programs. We don’t have to look far in history to see  how this will end up.  Looking at US history shows us that monetary unions do not work unless there is a fiscal union. It was 1787 in the US  and the states were bankrupt, with out a strong central government, states were resorting to issuing their own currencies,  and not coordinated at all in trade. Alexander Hamilton realized that the crisis had finally come to a point that the Articles of Confederation were deemed to be insufficient.  The solution to the crisis was for the states to give up their sovereignty and to establish a more powerful central government that could tax, assume the debts of the states, issue a single currency,  and issue bonds for the country as a whole.   At the height of the crisis in 1787,  John Jay  wrote “that America had no sooner become independent than she became insolvent”.   Now you might be wondering why Europe doesn’t do the same thing to fix their debt crisis.  The difference is that Europe lacks the political will and fortitude to give up sovereignty, to form a central government that can tax and issue bonds for the EU as a whole. So we at FXIB believe only two outcomes exist at this point: Mostly likely outcome to happen is that the EU breaks up and reverts to 1999. The other outcome is that in the off chance Europe does get its act together and start working as a team to resolve their political differences,  then we expect a government structure that is similar to the US which would support the Euro.

Why American Politicans Should Take Heed of EU Debt Crisis

Even though the US does not have the structural problems that the EU has, the debt load of the US is quickly reaching a point that is unhealthy for the economy and poses a threat to our economic security.  Bond vigilantes will not be pre-occupied with Europe forever and once the EU debt crisis reaches a conclusion they will more then likely turn their attention to the US.  We have already seen US yields sky rocket over the past two weeks, with the 10 year bond yield at 3.56% as the bond market prices in higher inflation and as the supply of bonds outstrips demand.  We at FXIB are split on how high bond yields will go, but what is clear is that the Bond Bubble over the last few years has burst.  Higher bond yields not only affect what kind of interest rate our government pays, but what kind of interest rate US citizens pay for mortgages, cars and  loans. And this is why our politicians need to pay attention to what Europe is experiencing, because if our politicians continue to spend and bury us in debt we will quickly end up like Europe with our own sovereign debt crisis.  For right now, the US is benefiting from the EU debt crisis with the US dollar gaining value against the Euro as more investors dump Euro assets and pile into US dollar assets.

How A EU Break Up Impacts Currency Traders and Investors

I’m sure we’ve all heard the motto: “Hope for the best, but prepare for the worst” this motto aptly reflects our outlook on the EU.   For a currency traders and investors, these are very interesting times. You have the US Federal Reserve printing $80 billion  more dollars a month which lowers the value of each dollar and dollar denominated assets, then you have the EU that appears to be on the verge of breaking up which is not providing any confidence in the Euro or Euro denominated assets.  What is a investor or trader to do? Until the EU debt crisis gets resolved we at FXIB are reluctant to hold Euro’s in our investors portfolios, we feel that it  presents too much of a unnecessary risk that we don’t want exposure to.  As for investors who may hold European stocks or assets denominated in Euro’s, you can protect your self by using Euro currency futures to hedge against a declining Euro  (of course this only works as long as the Euro remains solvent). In the unfortunate even that the EU does break up, we expect each European country to revert back to their own currency like it was in 1999.  There will probably be a fixed exchange rate for awhile giving investors/traders who hold Euro’s or Euro denominated assets an opportunity to switch to the “new” currency.

Conclusion

Unless Europe works together to resolve their differences, we see the odds of a EU break up ever increasing. We will be paying close attention to reports  over the next few weeks/months regarding the EU and debt crisis. And we hope that our politicians wake up and smell the roses so we don’t end up like Europe.