The Eurodollar Continues To Fall – Be Patient – The Next Big Move Is Down!

May 13, 2010

In the last week, we have witnessed a 1000 point intraday freefall and a 500 point gap higher in the Dow Jones Industrials. Fear of a European credit crisis rattled investors and officials quickly took action to restore confidence.

During the last few months, the EU has been indecisive. They debated on whether or not they should bail out one of its smaller members. This process reminded me of our credit crisis in 2008. Monetary officials wanted free markets to function and they were willing to let financial institutions fail. When Bear Stearns and Lehman went under, they quickly realized that magnitude of the situation and they took action. Last weekend, EU officials drafted a $1 trillion bailout plan for struggling EU members.

The market now knows that the EU stands unified and traders were able to focus on great earnings and low interest rates. A European credit crisis has been the only “fly in the ointment” and once those fears subsided, buyers returned in force. Unfortunately, the rhetoric from the EU is just lip service. Promises are easy to make and tough to keep.

Since the announcement, the Eurodollar has continued to plummet. Traders do not believe that EU members will bail each other out and debt levels have already reached the point of no return. Germany has been kicking and screaming throughout the entire process. It is the largest and strongest EU member and it has been reluctant to provide aid. Prime Minister Merkle has lost support after offering financial support to Greece and polls reflect a drop in popularity. Without Germany’s support, the rest of the EU will fail to exist.

The proposed $1 trillion bailout program has yet to be funded. Contributions will be made on an as needed basis. If the EU were serious, they would ask member nations to fund the program now. They won’t do this because most of the nations don’t have the money. For instance, Portugal and Spain were asked to contribute to Greece’s bailout. Both nations are in dire straits and they will be asking for aid shortly. Traders know that one “panhandler” can’t bail out another.

Austerity programs have been announced this week. The proposed cuts are miniscule and they will do little to balance budgets. In fact, not one nation plans a budget surplus in the next five years. They are simply trying to sink into the abyss at a slower rate. Meaningful cuts to pensions and retirement benefits are not being considered. As the population ages, this drain will escalate. This is similar to what we’re experiencing in the United States.

Social Security and Medicare/Medicaid comprise more than 50% of our annual expenses. Baby boomers are retiring and the government is paying out more in Social Security than they receive from payroll deductions. The CBO (Congressional Budget Office) did not project this to happen until 2016. We are six years ahead of schedule and we are sliding down a very slippery slope. When it came to proposed spending cuts, Obama put a spending freeze on a tiny part of our nation’s budget that accounts for 13% of our expenses. He did not cut spending; he merely promised not to increase a tiny portion of it. This is not going to balance a budget.

The bottom line is that politicians are not able to balance budgets. It doesn’t matter if it is Europe or the United States. Conservatives want to keep taxes low and liberals want to increase social spending. Both sides need to compromise in a big way and neither will. This problem will continue and we have already reached the point of no return. It’s just a matter of time until the market starts to price in default risk. That warning will come in the form of failed bond auctions and increasing interest rates.

When bondholders feel that the risk of getting back their principal has increased, they will demand a higher rate of return. That vicious cycle was starting to take root last week in Europe. Greece had barely received its aid package when interest rates started to climb in Spain and Portugal. The next victims were already being sized up.

The debt can has been kicked down the road for 40 years and it has reached a brick wall. The EU’s comments over the weekend stopped a market freefall, but traders will soon realize that these statements lack substance. The problem is too big and aid won’t solve it. Massive spending reform that starts immediately is the only solution. That will never happen because it will drive the economy into a recession. It is much easier to continue down the road we are on and when everything falls apart, blame it on prior administrations.

In addition to Europe’s problems, keep an eye on China. The economy that is supposed to pull us all out of a recession is slowing down. Construction is dropping off and their market is down 25% from the highs last August.

The snap back rally this week has set us up another shorting opportunity. Wait for the rally to stall and sell out of the money credit spreads on stocks that have been slow to rebound. If the SPY closes below 115, buy puts. Daily Report subscribers, focus on the bearish watch list. There are some great shorts that are already starting to drift lower.image


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May 12, 2010

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