Enough Dra(ch)ma: The Euro Will Thrive... When PIIGS Fly!

by Investment U Research Team

Enough Dra(ch)ma: The Euro Will Thrive... When PIIGS Fly!

by Gary Spivak, Investment U Research Team

Tuesday, March 2, 2010

What's your current F.U.D. level?

That is... Fear, Uncertainty and Doubt.

When it comes to situations like the Greek debt crisis, you want to make sure it's low. That's because if you want to profit from volatile events like this, the best way is to take the emotion out. Leave the F.U.D. to others.

That's what savvy investors do - and I'm going to show you how to do it here.

Many economists have weighed in with their take on Greece's troubles and whether it will be able to make good on its debt obligations while still remaining part of the greater European Union.

One of the best ways to play this problem is to bet against the euro versus the U.S. dollar. Why?

  • A fiscally weak Greece (plus the other so-called "PIIGS" nations) can drag down the entire Eurozone. That makes the euro less attractive versus other currencies - particularly the dollar.
  • Interest rates will begin to rise in the United States - a development that will make dollar-denominated investments more attractive.
  • The U.S. economy is rebounding faster than Europe's. It notched up a 5.9% annualized GDP rate during the fourth quarter of 2009.

So you can see that the stars are aligning for a pro-dollar, anti-euro trade.

But how could tiny Greece have caused all this mess?

Europe's Band of Bumbling Brothers

Around the same time that the North American Free Trade Agreement (NAFTA) was launched during the Clinton administration, European countries formed their own economic and monetary group - the European Union.

While NAFTA aimed to create a free trade zone (in particular, to open up more trade with Mexico), the European Union took this one step further. It decided on a common currency - the euro.

The Eurozone countries (Austria, Belgium, Cyprus, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, Malta, the Netherlands, Portugal, Slovakia, Slovenia and Spain) all use the euro - a landmark agreement that saw currencies like the French Franc, German Mark, Spanish Peseta and Greek Drachma disappear.

Upside: The prospects were encouraging. Like NAFTA, when goods and services move freely between economies, thus reducing or removing tariffs and other barriers, the positive aspects of free trade are realized.

Downside: With all nations using one currency, it means the weakest link(s) can compromise it. To combat this, the group established the euro convergence criteria, hoping to ensure that weaker countries wouldn't destabilize the currency. Greece met the criteria in 2000 and was admitted on January 1, 2001 (after the initial launch of the euro).

But with so many countries involved, it's virtually impossible to avoid pitfalls. It isn't just one country that causes concern; it's every country.

(By the way, if NAFTA gone in this direction, it would have established one common currency for the United States, Canada and Mexico. And while the dollar has certainly faced many challenges over the past few years, imagine if its worth was tied into the success of the Mexican Peso. A frightening prospect.)

So how does Greece fit into this mess?

Greece Stumbles Through Europe's Back Door and Causes a Ruckus

Eurozone members agree to abide by a number of criteria, including limits on inflation, budget deficits and national debt. While many nations have flouted one or more of the restrictions, many have said that Greece is the worst offender.

Why? Because its old currency - the Drachma - was already weak and in exchanging it for the relative security of the euro, it stood to be better off.

So in sum: You had a nation that needed to become part of a broader economy and currency. You had a nation that perhaps exaggerated the strength/stability of its economy. And plopped within a fledgling economic zone, dedicated to rivaling North America as the world's largest.

Good call!

The Euro Is Set to Fall Versus the Dollar

The Eurozone is well aware of this crisis and has a number of potential responses...

  • It could simply kick Greece out. But the ramifications would be severe. With other economies under question (the rest of the PIIGS, for instance) the world would simply wait to see who got booted out next. And since markets hate uncertainty, this would undermine the very foundation of the Eurozone.
  • Europe could bail Greece out. However, doing so would imply that the next country to teeter would also be bailed out. Europe seems to be headed in this direction. And while it could save the euro, it's likely to weaken investor confidence.

In a free trade world, currencies have value relative to other currencies. It's quite often a zero-sum game. So here's why the U.S. dollar is set to take advantage of this situation...

If doubts about the Euro persist (and those doubts aren't likely to disappear anytime soon), the euro's prospects will have greater F.U.D. That means investors will likely flock to safer havens like the dollar.

Given that the dollar has taken a beating for several years and that U.S. economic prospects appear to be more promising than Europe's in the near-term, I anticipate the flow of funds to move from the euro and into the dollar. You can play this in a number of ways...

  • Go long or short on the dollar and euro.
  • Use foreign-denominated CD's. EverBank's Dollar Bull CD allows you to take a bullish long-term position on the dollar, versus the euro.
  • Invest in ETFs: The PowerShares DB US Dollar Index Bullish Fund (NYSE: UUP) is bullish on the dollar versus other world currencies. Alternatively, the UltraShort Euro ProShares (NYSE: EUO) would be an aggressive anti-euro play. The ETF seeks to replicate twice the inverse of the euro/dollar daily price change.

Good investing,

Gary Spivak

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