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All Eyes on the Euro

Drop your investment thesis and watch the currency markets.  Nothing currently matters except for the state of the Eurozone and its ultimate resolution.  The actions of the European members have been lackluster at best with many areas of contention and finger pointing.  The fact is that they need to resolve the current crisis before they can dissolve the broken Eurozone contract.  The problem has nothing to do with the size of a Greek default and everything to do with the freezing of the European financial system.  Banks stop lending to banks and the issues only magnify.  Fear begets fear.  The Euro has dropped nearly 20% since the end of last year and has shown no sign of stopping:

As long as the Euro is crashing then volatility will be high and the risk-reversal trade takes flight.  Amusingly, this means that money is being pumped into the dollar and dollar denominated bonds:

The crux of the European debt contagion is that the Eurozone has thrown money at the issue with no clear plan.  This whole skit looks much like the ballet performed by the federal reserve in 2008/2009, but in this case we have to get the political heads of many countries to agree before action can be taken.  The only actions that will satisfy market participants involve painful austerity measures that seem to be on the political back-burner.  In addition, we have slight jabs where France’s Sarkozy threatens to leave the Eurozone and then Angela Merkel creates tension of her own by saying that, “to some degree this is a battle between the politicians and the markets…but I am firmly resolved to win this battle”.  These are hardly statements that are calming to a jittery market.

From an investment perspective, this market is difficult to navigate.  Stocks have shown significant weakness globally and yields on most bonds have plummeted.  There are a few ways to take advantage of the dislocations:

  1. Sell Volatility.  From a mark-to-market perspective, you might take unrealized losses in the short term, but you can expect that over the coming months you can expect volatility to relax into a 20-25% range at some point.  A 30% VIX and 30% going out many months suggests that the daily standard deviation of the S&P 500 will be .3/sqrt(252) =~1.9% per day.  That is a lot of movement over months and years.  Look at short positions inVXX and VXZ as simple ways to implement that trade.
  2. Buy investment and non-investment grade spreads while hedging rising interest rate risk.  High grade corporate spreads have gapped from about 1.25% to 1.55% while the ten year treasury rate has fallen from about 4% to 3.33%.  Buying LQD gives you exposure to corporate bonds and some of that duration risk can be hedged with short ten year futures, short treasury ETF such as TBT or puts on TLT.
  3. Diversify out of dollars.  The dollar index (DXY) has shot up to 87.5 which is a short hop from the financial crisis high of 89.1 back in March of 2009.  A fall in the Euro has created much of the spike, but the flight to “quality” has ignited it further.  If you are a gold bug, GLD fits the bill.  If you want solid currencies – the Australian Dollar, the New Zealand Dollar, the Canadian Dollar, the Norwegian Krone, or the Korean Won seem like decent places to store some real value.

Posted in Derivatives, Economics, Markets, Politics, Trading Ideas.

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