Why Is The Euro Dropping?

The Euro is dropping fast right now, dragging other risk assets with it.  So far, there is no good explanation, but the assumption is that someone “knows” something, and that something is bad.  Neither are a surprise.  With so many governments and international agencies involved, leaks are to be expected, and since all that the EU has done is to paper over the problems, it isn’t hard to believe that it is about to crumble again.

Well, maybe as the banks and sovereigns and ECB become fully integrated someone has realized how bad the average European sovereign is.  Maybe the games played by the Italian banks (to get a government guarantee on their own debt that they issued to themselves so they could take it to the ECB to get money to buy Italian government bonds) are being noticed by the rating agencies.  Maybe even the market is paying attention to that convoluted trade.  As banks and countries become completely intertwined, it is not the “sovereign ceiling” the markets need to worry about (where a corporation shouldn’t trade tighter than the sovereign), but the race to the bottom we need to worry about.  If it is all interconnected, then it is the weakest institution that drives prices.

Maybe someone realized that France has its own debt, the debt of EIB, obligations to the EFSF, the ECB, Dexia, and who knows what else.  Maybe a 1 notch downgrade for France is the best case.  A consolidated balance sheet would look horrific.  If someone really took into account what France would have to pay if all their guarantees were exercised, the debt to GDP is not good.  And why shouldn’t people consolidate the guarantees?  They are NOT free, there is a cost.

Maybe Europe will trend towards an “average” rating.  But if all the debt that all the sovereigns have taken on or guaranteed or are otherwise obligated to pay, is taken into account, that average may well be A+.

Maybe it is the fact that on December 22nd, the IMF said that it lacked the necessary votes to implement a 2010 decision to double its permanent resources?  I’m still trying to find the press release, but isn’t this money that has already been priced in (multiple times) to the bailouts?  Certainly this would show that the IMF isn’t about to grow, but it might now even have as much as the market thought?

Maybe it is the realization that Greece will have to default to get the restructuring done.  Hedge funds aren’t going to “voluntarily” agree to anything.  They can’t get the banks to agree, let alone hedge funds.  Greek bonds already have largely priced in a default (some front end bonds might sell off a bit, but they are all trading at pretty low prices).  What isn’t priced in is the implication of a default.  What will happen to sentiment once a default occurs in Greece.  Will people really believe that Portugal and Spain aren’t headed down that path?  Especially once Greece wipes out 60% or more of their debt?  What about the ECB holdings?  Those weren’t included in the restructuring.  Far harder to exclude them in a hard default.  What does that mean for ECB contributors (remember, it is joint and several, so worse for Germany and France than EFSF).

The sad truth is that someone probably does know something, and although we may bounce back from this brief sell-off, none of the issues mentioned are going away and will need to be dealt with.  Santa has come and gone, now its back to reality, and that reality has a lot of hurdles that need to be cleared before stocks can justify higher prices.