How to Trade the Euro Debt Crisis

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In earlier articles I've covered the profit potential of trading the sideways movement between the EUR and USD by buying the lows of the range and selling the highs. As you will remember, the key to this trade was having equal, 1% growth by both economies. The main thing to watch for is for one or the other country's economy to outpace the other. One of the ways that we could see the US economy outpacing the EUR in growth stems from Europe's debt issues. And, lately, we have seen a temporary break down of the EUR/USD as a result of recent bad economic news from Europe.

The backdrop

Concerns remain of course about the United States debt issues and turmoil over oil supply from Libya's revolution. Despite these issues, many economists think that the European debt crisis is a greater threat. The debt crisis could threaten to sink the European Union as the severe downgrades of debt for Italy, Portugal, Spain, and Greece all would require intervention. And, don't forget, Ireland has debt problems, too. The fact that so many nations have serious issues with debt that require massively expensive bailouts understandably makes investors nervous.

Also, a major obstacle to recovery is that the market seems to have already priced in intervention. This means when the EU intervenes to help these nations there will be little new buying of the EUR. There will also be less chance of surprise recovery from intervention. On the other hand, not helping those nations will have a huge negative impact. These concerns were confirmed when the Societe Generale made a surprise announcement to cut costs and raise 4 billion in EUR. Banking stocks slowed their decline but didn't make any gains and still lost some value after the announcement.

And, although China's growing inflation pressures and global oil prices are problems, many traders see the European debt as the more immediate threat. This is because European debt crisis has the greater potential to cause a repeat of the 2008 market shocks.

Why?

Because the stability of Europe's debt situation remains in question.

European Central Bank (ECB) President Jean-Claude Trichet has publicly asked Italy to keep their word with debt-cutting measures. Bank stock prices in France continue to fall. France may well need to recapitalize its banks. Add in Portugal and Greece each rejecting austerity measures and we see why European debt is so volatile. Some traders believe that the EUR/USD may test the lower end of recent trading range between $1.32 to $1.30.

However, as bad news spilled out about the Euro, the USD rallied strongly despite the lack of recovery in the US economy.

The concern over Europe's debt will not go away in the short term in part because new reports always seem to flare up. First it was the Irish situation then the Greek riots from a year ago. Portugal is the latest nation drowning under the weight of its debt and Italy is also struggling. France is one of the largest economies in Europe so when they talk about needing to recapitalize their banks it becomes hard to ignore.

Portugal has already had their debt downgraded and will not be the last European nation to face this issue. Portugal, Ireland, and Greece are in the riskiest shape, but the bailouts for these nations are already priced into the market. This means every new fear-based sell off in the EUR will result in a new injection of Euros to calm markets.

The 5-year EUR CD is a good way of gauging what traders feel is the riskiest or least risky debt. Even the nations with debt are put in different categories. Greece, Portugal and Ireland are seen as a riskier group. Spain and Italy have concerns but not at the same level. This can be seen because previous spikes in credit default swap prices for Greece, Portugal, and Ireland also came with an increase in corporate bond yields. So far in 2011, the increase in Greek CDs has not stopped spreads from tightening on corporate bonds or U.S. Treasuries.

A big question is what to do if Europe was faces a major default. History says that traders will sell off in stocks, bonds, and other investments. This could mean that U.S. treasuries would be seen as the safer investment. That safety would lead to that investment becoming crowded very fast and send the USD higher against the EUR.

So what do we watch out for?

France and their bank recapitalization is the main situation to watch.  Keep your eye on France because they may recapitalize but they may put it off as well.

Finally, we need to watch the Fed's action to boost the US economy, such as a surprise announcement of further stimulus. If Fed intervention happens at the same time a European debt crisis explodes, then it could definitely change the relationship between the EUR/USD.

What we have seen this past week is the EUR/USD move higher on news that the EU will not let their banks fail. This means that a bailout is in the works. Look at the chart below and you will see the reversal to the upside. If the EUR/USD closes above 1.4000 this week, then we will see price move back into the previous channel between 1.4100 and 1.4550.

A weekly close above 1.4100 will trigger a SquishSquash (my proprietary counter-trend system) buy signal with a stop loss at 1.3949 and a 1.4549 profit target to exit.

To your success,

Jason Fielder

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