“I have nothing against the [common currency] apart from its name — I think it should be called the deutschemark.”
– Helmut Schlesinger, Bundesbank president, 1992
I am thinking of a period of unprecedented stress in the currency market. After years of progress by Eurocrats, the economic union appears to be imploding. Europe’s leaders face the impossible task of threading the needle between Greater Europe and the ire of the constituents back home. George Soros has his finger on the pulse of the currency market, and has no qualms about wagging said finger at policymakers. Back home in the U.S., a president who breezed into office a mere three and a half years prior, suddenly finds himself fighting for his political life due to a stubbornly persistent recession.
Does this situation sound familiar?
Veterans of the currency market knew right away I was talking about 1992, the year of the “currency crisis.” In June of that year, Denmark voted down the Maastricht Treaty, threatening to scuttle decades of progress toward a monetary union. Mr. Soros took on the Bank of England and won, with the Pound dropping out of the ERM on September 17th.
On a personal note, I was two months into a new phase of my trading career – managing my own account as an FX options market maker after having left the banking world. I had never seen a 20 big-figure move before, nor had I seen volatility literally double in the blink of an eye. A small short gamma position – a rounding error by bank standards – was substantially bigger than it looked. Lesson learned.
The point of this trip down memory lane, as you may well have guessed, nothing is ever as bad (or as good) as it seems. Europe will muddle through the current crisis and, regardless of the ultimate outcome, will likely emerge stronger as a whole. At minimum, the imbalances that have been building in the system will be worked out, just as they did in 1992.
In the meantime, though, how does one handicap the eurozone? By all appearances, all roads lead to pain in the short term. An economy cannot grow in the short term through austerity. But additional bailouts are tantamount to throwing good money after bad.
We must also remember that each nation is not a single voice, but rather a consortium of diverse opinion. It is easy, from the outside, to say “Germany should do this,” or “Angela Merkel should do that.” Perhaps she would like be the savior of the eurozone, but if she defies the will of the people, her political career will not survive next year’s election. It appears right now, the will of the German people is austerity in the periphery and no fiscal union. A majority of Germans would not mind seeing a return of the deutsche mark. Go figure.
Another eurozone summit begins Thursday. Expectations are quite low that any progress will be made. Mr. Soros, who may be talking his position, has said that the common currency may dissolve if no solution is proffered this time. The latest idea, to be floated at this week’s summit, is one of strict debt limits, with budgetary oversight by the EU if limits are breached. Will it be agreed to and, if so, will it be enforceable? Remember that deficit targets, which were supposed to keep everyone in line, were completely ignored when the economy went south.
So, how to play it? Perhaps a German bond with a negative yield is not such a bad buy. The current yield on a 1-year German note is a negative 6 basis points. Earlier this month, the 2-year Schatz briefly turned negative. Irrational levels of risk aversion, you say? Not necessarily. What if, instead of booting Greece from the euro, the Germans decided instead to go their own way? Buy a German bond today with euros, and get paid at maturity in D-marks. The pundits have been suggesting that a German currency would be worth 30 percent more than today’s euro.
Not too shabby. Mr. Schlesinger would be proud.