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Stocks have enjoyed a pretty consistent rally over the past several weeks. The market has risen based on the prospects that, for the first time since the European crisis began in 2010, its leaders really want to craft a solution, instead of constantly enacting last minute policy changes to avoid a catastrophe.
Despite the fact that no real actions have been taken!
Markets, since May, have been totally directed by the goings on in Europe. And we can see that as recently as last week when the media focused its attention on the “rate cap” the ECB wants to use to keep euro-member countries’ sovereign yields under control.
Last Sunday it was Der Spiegel that reported the details of the possible move by the ECB. And that speculation was further confirmed by The Telegraph mid-week, and then by Reuters on Friday. That Reuters article was the main catalyst behind Friday’s short-covering rally.
What Is the Rate Cap, and
Why Does It Matter?
The rate cap would require that the ECB begin buying a European nation’s sovereign debt if that country’s bond yield reached levels deemed too high, say for example 8 percent on 10-year debt.
If this were actually implemented, it would be a big positive for two reasons:
First, it allows sovereigns to continue borrowing money, thus avoiding bailouts like Greece, Ireland and Portugal desperately needed.
Second, and more importantly, it shows that the ECB is finally willing to put up whatever is required to support the euro and the euro zone. The ECB has the capacity to print unlimited euros and buy sovereign debt with that money. This would overwhelm short positions and sellers in the market, and keep rates in order.
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| If the ECB sets a rate cap, it’s bound to send the euro sliding. |
While it’s unlikely that printing unlimited euros would ever happen, just the fact that the ECB says it may happen is enough to ward off shorts in Spanish and Italian debt. Plus it’ll ensure that those countries can continue to borrow money and avoid a Greece/Ireland/Portugal style bailout.
So if the ECB adopts a “rate cap,” it would be a big, game-changing positive for the markets.
Of course, though, we have to remember we are dealing with Europe. And while the hope of something positive being done is responsible for the summer rally, we are now where the proverbial rubber meets the road.
Over the next two months, European officials will have to actually follow through on their grand rhetoric, and produce concrete plans and actions that will stem the crisis. If they don’t, we can expect to see trouble emerge once again in the markets.
Regardless of the ultimate outcome, though, there is a clear loser in all of this: The euro, which is faced with two possibilities:
• If a “rate cap” or similar measure is adopted, it will mean more printing of euros and more economic stimulus — which is bearish for the euro …
Or …
• If European officials maintain the policy of talking a big game but never following through, it would eventually lead to a Spanish and Italian default, and the breakup of the euro zone as we know it — which is obviously bearish for the euro.
In either case, the euro is bound to go lower. One way to play a decline is through the Proshares Ultra Short Euro ETF (EUO). This leveraged inverse ETF is designed to rise 2 percent for each 1 percent drop in the euro.
Best,
Tom
Tom Essaye oversees Weiss Group’s Million-Dollar Contrarian Portfolio, in which company founder Martin D. Weiss has staked $1 million of his own money.
Tom began his financial-services career at Merrill Lynch, where he worked on trading desks on the floor of the New York Stock Exchange. While on the floor, he managed multi-million dollar equity trades from some of the biggest hedge- and mutual-fund firms.
