PIMCO vs Spain

From today's WSJ:

Prime Minister José Luis Rodríguez Zapatero declared that the European debt crisis is over but said that the governments have to work better together and with markets to stave off such events.

"I believe that the debt crisis affecting Spain, and the euro zone in general, has passed," Mr. Zapatero said in an interview with The Wall Street Journal on Tuesday.

Mr. Zapatero said his message is that "confidence has been restored," particularly after the country released results of tests that evaluated the soundness of its banking system in late July. The risk aversion toward Spain has also subsided as the government has shown progress in reducing its deficit. 

PIMCO is saying the exact opposite.

“Market measures of risk for peripheral European countries (Greece, Ireland, Portugal and Spain) are at or near danger levels,” El-Erian wrote in an article posted Monday on Pimco’s Web site.
That’s despite “exceptional” support from the European Central Bank, the European Union and the International Monetary Fund, he added.
“The failure to reduce risk spreads means that the public sector bailout is not working,” El-Erian wrote. Rather than provide assurances of better times ahead and, thus, encourage new investments, ECB/EU/IMF support funding is being used by existing investors to exit their exposures to the most vulnerable peripheral European countries.”

I don't always agree with PIMCO as I believe that they are often talking their book (by pushing for government intervention in Fannie/Freddie while they hold billions of their bonds). Spain is "talking their book" as well, as they hope to build confidence in their economy and their bonds. However, in this case, I side with PIMCO.

History is littered with these types of statements just at the time that crisis worsens. In May 2008, there were tons of declarations that the credit crunch was over, when in reality, it was only a pause before the real credit crunch started.

The Euro is approaching its summer highs at 1.34 as it ignores the developments that PIMCO highlighted, but I believe that before the year is done, we should see a return to the 1.15-1.25 range that I highlighted back in late 2009 when the Euro was near 1.48.

Ultimately, the Euro is heading back to par or lower but that may be something for 2011 or 2012. I believe that a super strong US dollar would wreak havoc on the stock market.

Disclosure: Position in the Euro and US dollar.

Great interview with Robert Prechter

I wanted to pass along this great interview with legendary Robert Prechter of Elliot Wave International. Mr Prechter wrote an amazing book, Conquer the Crash back in 2002





and updated it in 2009,







Much of what he predicted is happening, albeit much later than even he had thought back then. I highly recommend this book. It predicted the demise of Fannie, the current deflationary depression, the meltdown in the financial system, etc...


Anyway, this interview by the Daily Crux explains the deflation camp thesis very well and also surprisingly mentions Toronto (and Canada by extension)...

Crux: Well, not everything. Gold is at all-time highs...

Prechter: And so are Toronto real estate and vintage wine. But let's put these markets in perspective.

Prechter goes on to say later:

Here in 2010, a few late bloomers are making new all-time highs. I never thought the long-term inflationary topping process would take this long, but it has.

At each of these peaks, investors have focused on one area or another. Every time it's happened, the area of focus has reversed trend, plummeting in price by 50% or more. 

This latest credit reflation is the weakest yet, so it hardly inspires confidence that today's isolated bull markets will end any differently. Each time a bull market matures, investors are sure it can't reverse. They said that about technology and Internet stocks; they said it about real estate; they said it about oil.

Now that a couple of markets are at all-time highs, we hear the same argument about them. This is natural, because investors always want to own markets that are way up. But investors in those previous booms are never going to get back to break even. Many of them were ruined.

Imagine a 50% price drop in Toronto!...Ultimately, I believe that the US real estate market is heading to a roughly 50% crash (it is at 30% right now). It sounds crazy to think that Toronto (and much of the Canadian real estate market) are going to drop 50% as well, but the history of bubbles indicates that as "today's isolated bull markets" reverse, such a drop may indeed happen.

Your parents' advice is wrong!

Now that all the Obama adminstration housing gimmicks are finished, housing is heading back down after a brief bounce the past year.

I believe that all these gimmicks did is postpone the decline, waste taxpayers money and favor those that made mistakes with their housing decisions.

Housing sales dropped 27% to their lowest level since 1995, and point to a renewed drop in prices in the months ahead. The news was not unexpected, and adds to the recent dismal news in retail sales and unemployment. The only positives that I can see in the US economy right now is the ISM is still positive and corporate profits are strong. The ISM may turn soon and it will be interesting to see if there are any earnings pre-announcements in the coming weeks that point to weakening profits.

I also found this WSJ article interesting:

In an annual survey conducted by the economists Robert J. Shiller and Karl E. Case, hundreds of new owners in four communities — Alameda County near San Francisco, Boston, Orange County south of Los Angeles, and Milwaukee — once again said they believed prices would rise about 10 percent a year for the next decade.
With minor swings in sentiment, the latest results reflect what new buyers always seem to feel. At the boom’s peak in 2005, they said prices would go up. When the market was sliding in 2008, they still said prices would go up.
“People think it’s a law of nature,” said Mr. Shiller, who teaches at Yale.
For the first half of the 20th century, he said, expectations followed the opposite path. Houses were seen the way cars are now: as a consumer durable that the buyer eventually used up.
The notion of housing as an investment first began to blossom after World War II, when the nesting urges of returning soldiers created a construction boom. Demand was stoked as their bumper crop of children grew up and bought places of their own. The inflation of the 1970s, which increased the value of hard assets, and liberal tax policies both helped make housing a good bet. So did the long decline in mortgage rates from the early 1980s.

In the US (and especially California), people STILL expect housing to go up 10% a year! With inflation near zero, that is an astronomical assumption. That would put housing prices at record highs (even after inflation) by the middle part of this decade. These people just assume that what happened over the past few years was just a correction.

It is interesting how the housing wisdom of the Baby Boomers and the Silent Generation (in the parlance of Howe and Strauss) is actually not sound advice. And I hear it all the time from people my age and my parents generation. Even after the events in the US of the past few years. Renting is throwing away money in their view. Throughout most of their lifetimes, it was and housing has produced incredible wealth. In reality, it really was but a rare confluence of "a 100 year flood" type events concentrated in about 25 years.

Even in the best of years before the 1997 housing bubble, housing returned about 1% above inflation. I think it will take another 5-10 years to kill this 10% mentality (via a renewed 20-30% drop in home prices in the US over the next few years, followed by little or no appreciation for another few years). Then, maybe, housing will return to its traditional role as a necessary consumer durable but not an investment for most people.

US GDP contracted in May & June

As a follow up to my view that a double dip has started(if indeed the recession truly ended- I don't believe it did!). Courtesy of Gluskin Scheff's David Rosenberg, whose awesome daily publication is free(!!):

Our suspicions have been confirmed — the recession never ended. Macroeconomic Advisers produces a monthly U.S. real GDP series and it shows that the peak was in April, as we expected, with both May and June down 0.4% in the worst back-to-back performance since the economy was crying Uncle! back in the depths of despair in September-October 2008. The quarterly data show that Q2 stands at a +1.1% annual rate (so look for a steep downward revision for last quarter) and the “build in” for Q3 is -1.5% at an annual rate. Depending on the data flow through the July-September period, it looks like we could see a -0.5% to -1% annualized pace for the current quarter. Most economists have cut their forecasts but are still in a +2.5% to +3.5% range. What is truly amazing is that despite all the fiscal, monetary, and bailout stimulus, the level of real economy activity, as per the M.A. monthly data, is still 2.5% below the prior peak. To put this fact into context, the entire peak to trough contraction in the 2001 recession was 1.3%! That is incredible.

As I stated in June:

I believe that double dip has likely started. Yes, I know that economists have solid growth projected for 2010. I listen to the market, which is speakly very loudly right now. By the time, these bookish economists wake up, the S&P will be at 850.

As the great Bob Hoye has researched, in a post-bubble credit contraction, the economy and stock market often peak at the same time. The high in the 1873 and 1929 stock market was was September, and the respective depressions started in October and August respectively. In 2007, the stock market peaked in October, the recession started in December.

This clear peak in April, if it holds and if the stock market continues to sell off, likely means that a double dip has either started or will start very soon.

Now, I incorrectly thought that we would hit 950 in July (the lowest was 1010), but I have not changed my view about 850 by October as a recession becomes factored in as a possibility by the economists on Wall Street. Currently, they are bringing their numbers down to the slowdown camp. There are few forecasting an outright recession at this point, despite the fact that Q2 GDP will be revised down to 1.5% and Q3 looks even worse.

Now that Macroeconomic Advisers has put out a negative number for May/June, this lends credence to what I stated. The horrible economic data of recent weeks is also further confirming my suspicion that as is typical in a post-bubble credit contraction, the economy and the stock market peak at the same time. Using ISM as a guide for monthly GDP, it peaked in April. So did the S&P at 1220.

A double dip recession is by no means confirmed, but it is becoming more and more likely by the day.

Disclosure: Positions in HSD, SDS and related options

The "New Normal"

PIMCO has been saying that the economy is in a "New Normal" whereby the world economy will grow slower, be more regulated, have higher unemployment and continue to deleverage.

Earlier in 2010, when the cyclical rebound was in full swing, the New Normal was derided.

Bloomberg in January had an article featuring critics of the New Normal:

Christopher Rupkey, chief financial economist at Bank of Tokyo- Mitsubishi UFJ in New York, who pegs potential growth at 2.6 percent. “We’ve had financial-market crises and big workforce changes before, and growth has pretty consistently come in around 2.5 percent over the past 50 to 60 years.”

I won't profess to know what the economy will do over the next 50 to 60 years. It is indeed possible that growth could come in around 2.5% or even better. What I do know is that the past 50 to 60 years have featured an incredible debt buildup, especially the second half of that period. If we do grow at 2.5%+, it will be not be fueled by bubble credit. That 2.5% will need to be based on a more sustainable and more efficient foundation.

The jist of Pimco's new normal is that the bubble credit that fueled growth the past few decades is over. The de-leveraging will lead to slow growth for at least 3 to 5 years. This is not your normal post WWII recovery (if it is indeed a recovery).

Is it normal that:

1) Nearly 3 years after the recession started, the unemployment rate is near 10%?
2) That trillions of dollars were used (wasted?) on quantitative easing (QE)?
3) That house prices and stock prices are 30% below their peak AFTER a one year rebound?
4) Interest rates are at zero and will likely remain there for an extended period?
5) Annual deficits are measured in TRILLIONS!? We used to shudder at a $200 billion deficit.
6) One year in to the recovery, we are contemplating a second trillion dollar QE?

And yet, despite these (and numerous other proofs), much of Wall Street plugs in typical 2.5% growth for the next few quarters and years, as if things are the old normal.

The debate about the New Normal will likely be resolved soon. Perhaps the economy will grow at 2.5%+ the next few quarters (I don't believe it will), but it likely will not be in the old normal way (where the recovery is self-sustaining). It would be based on more of the same short term solutions that will, at best, buy a little more time. The public is growing weary of these short term band-aid solutions that bankrupt the future for dubious short term gains (hence the Tea Party and plummeting Obama ratings). I believe that the November mid term elections may be very big this year, perhaps similar to November 1994.

Are Obama/Bernanke going to try to pull a few rabbits out of the hat the next few weeks in an effort to avoid a double dip and shore up the prospects for the Democrats? I believe that the American electorate is getting suspicious of the never ending stimulus, and this may lead to even greater voter anger in November. However, Obama seems to be in his own world right now, and sticking to his liberal agenda, despite the fact that US is not a liberal country.

Ultimately, another 2008 crash is coming, once the New Normal becomes the consensus, and we realize that all the gimmicks are not addressing the underlying cause of this mess (too much debt). Just not sure when that happens, but it is likely to happen around the same time as the public anger rises to a peak.

Double Dip Recession likely has started

I believe that we are in the midst of a hurricane that will eventually take out the March 2009 lows, perhaps later this year or in 2011.

Since late April, the S&P has dropped about 15% from 1220 to 1030 at the close today. I expect that we will hit 950 by late July, and 850 or lower in August to October.

This started with Greece but is now much bigger than Europe. This is the market pricing in a double dip recession.

I believe that double dip has likely started. Yes, I know that economists have solid growth projected for 2010. I listen to the market, which is speakly very loudly right now. By the time, these bookish economists wake up, the S&P will be at 850.

As the great Bob Hoye has researched, in a post-bubble credit contraction, the economy and stock market often peak at the same time. The high in the 1873 and 1929 stock market was was September, and the respective depressions started in October and August respectively. In 2007, the stock market peaked in October, the recession started in December.

This clear peak in April, if it holds and if the stock market continues to sell off, likely means that a double dip has either started or will start very soon. Recent economic reports have been very bad (retail sales, housing, employment) and lend credence to this likelihood.

I will let John Hussman argue the case based on economic fundamentals:
http://www.hussmanfunds.com/wmc/wmc100628.htm

This double dip is being caused, in my opinion:

1) by the end of the natural cyclical rebound from the 2007-2009 GDP decline
2) the waning impact of a ton of stimulus and printing money
3) A slowing in European and Chinese growth
4) the reemergence of the underlying credit contraction that will take years to complete
5) the end of the US dollar carry trade that I had discussed for months

In 2009, governments were printing and spending money to no end. Now, in 2010, restraint (except in the US) is the name of the game. This restraint is ultimately healthy but will take years to restore government balance sheets. In the meantime, the natural rebound is winding up and the deflationary beast is back.

It is hard to predict how long this double dip will last, but my gut tells me about 12 to 18 months, therefore into late 2011. David Rosenberg has it right when he says that this depression will have a series of recessions. It appears that number 2 has started.

Disclosure: Position in SDS, Euro, US dollar

Black Thursday (1000pt down day)

While there were glitches on Thursday, I don't buy the trader error story to explain why Accenture traded at 1 cent or PG was down 37% intraday.

The Yen was up about 3 Yen vs the USD (and even more vs the Euro) before any crazy trading happened in New York.

There is a lack of liquidity as the huge government bond market seizes up, especially in Europe. In addition, the huge moves out of the Euro (I think bank runs are part of this) and into gold, USD and Yen, is also putting huge pressure on leveraged equity players and hedge funds.

The electronic trading and the few remaining players in the game are also adding to the volatility.

I believe that Black Thurdsday was not a fluke but a warning shot that systemic risk is very much alive. Listen to the market. It is not healthy at all.

This is why I have written about Greece

I haven't had much time to write for my blog due to work and family obligations. However, most of what I've written has been about Greece and the Euro.

Why such emphasis on a country of 11 million (the size of Ontario)?

Greece is the fault line. I have believed that the impending default of Greece, despite a "shock and awe" bailout that I didn't think would happen, is the catalyst for:

1) the end of the tight credit spreads for most insolvent countries. This is consistent with the history of great credit bubbles. This means a Seinfeldesque "no soup for you" to the international bond markets for Greece and the rest of the PIGS. There is too much debt out there, much of it will never be repaid.
2) the end of the Euro as we know it, and a huge dislocation in currency flows
3) A relatively strong US dollar
4) The re-start of the bear market that was interrupted for 13 months.
5) Another banking crisis as all that government debt becomes devalued and countries pull out of the Euro.

It is difficult to predict the future, but I am very worried that a redux of late 2008 is back.

There are still way too many bulls out there who think that this will be contained. I now fear that we have re-entered the September 2008 to March 2009 playbook where volatility rules and anything is possible.

I now believe that a quick 30% from the highs is possible over the next few weeks and months (mid 800s S&P), as things can unravel very quickly if the Euro goes to par in that time, and if multiple countries default, with bank runs and a powerless ECB.

One of my weakness is that I often see things before they happen. I had been worried about a bear market for years (pre-blog). I warned prematurely about a housing bubble bursting in Canada. I have been bearish on the Euro for years. I wrote about a currency crisis in 2008 that didn't fully materialize. I was looking for a huge bear market rally a few months early in 2009 and then I turned bearish too quickly.

This time I fear that I am being too slow in that I have not fully positioned myself for a 30% move that could happen in weeks not months.

I am not predicting this just yet, as the reversal is still new, but one possible doomsday short term scenario over the next 2 months:

Euro to par, maybe in the next few weeks. (Note that we almost hit my 1.15-1.25 range yesterday)
CAD to weaken to 85
S&P to 850
Gold to 1,500
Yen not sure

Risk is very, very high right now.

Disclaimer: I am currently long USD and CAD, short Euro, long gold.

Another month, another Greece bailout

On February 11th:

“In theory, we will help Greece. But they haven’t asked for any money (wink-wink). Go about your business, quit speculating against Greece and let us get back to our bureaucratic plans to form a true European nation ”

Eventually, the market realized that this is just talk.

On March 25th:

OK, OK, we have a mechanism to bail out Greece and the IMF is involved, but we’re not giving you the EU taxpayer any details. And anyway, they haven’t asked for any money. There, that should end the matter!

On April 11th:

Alright then, you leave us no choice. Here are some details. We will sort of gloss over the fact that all EU members must approve this aid, and that it might even be illegal according to the EU charter.

That means that the German, Italian, Irish, Spanish and Dutch parliament (among others) must pass this aid BEFORE it gets disbursed. The IMF could lend without approval (meaning Canadian taxpayers are going to be involved) so perhaps the IMF would do the initial bailout and then the EU would kick in the rest. However, given my admittedly weak knowledge of the history of Germany, I have my doubts as to whether it would pass. What about the Irish parliament? They have taken draconian steps to balance their budget without a cent from the EU. Are their suffering taxpayers going to send money to the notoriously inefficient Greek taxpayer? All it takes is one government to reject the aid (think Meech Lake).

Greece said on April 11th:
The package “sends a clear message that nobody can play with our common currency and our common fate,”

Economic and Monetary Affairs Commissioner Olli Rehn:"There will be no default."

When Greece defaults, what will they say?

At this does is send a clear message that the EU, especially Germany, does not want to set a precedent here by bailing out Greece. It may have to, but it is scared. The IMF can do what it wants.

I believe that Greece will default and get an IMF (not EU) bailout. It needs to restructure its debt and then decide whether it stays in the Euro or goes back to the drachma.

Then the saga moves to Portugal…I am sticking with my 1.15-1.25 2010 target established back in December for the Euro. So far, the US dollar carry tread (negative S&P/USD correlation) has busted in 2010. Let's see if it continues if the Euro continues to sink.

Ironically, if Greece and other Club Med members left the Euro, one day (far, far away though) perhaps the Euro would actually be stronger.

Disclosure: Position in HSD.TO, SDS, EUO, US & Cdn cash

Little March Break

I have not been able to post of late, as I have welcomed a new member to my family, and I have been a little busy (and sleep deprived) of late.

I plan on posting again soon. My big picture view has not changed but I must admit that I am amazed at the resiliency of the bulls. We are yet again at a possible inflection point, where the market can either go up to S&P 1230 or retest the February low/start a new downleg. March is often a key turning point in the markets (2000, 2003, 2008, 2009) as we approach the equinox and the ides of March.

Thanks for all the flattering comments. One generous reader noted that the Tip Jar was busted. I have fixed it now.

All the best....

Dominoes and Euro updated

Euroland crisis: I posted my target for the Euro in 2010 (1.15-1.25) back in December when the Euro was near 1.50. It seemed far fetched.

Now that we are at 1.38 2 months later, it doesn't sound quite so outlandish. Morgan Stanley was correctly bearish at the time, and now dropped their target to $1.24 from $1.32. They feel that the Euro is overvalued by 19%. An overvalued currency in the midst of a crisis. The Euro is currently oversold and could bounce at any time, but I believe we'll see 1.30-1.32 pretty soon. The Euroland crisis was discussed further last month and now, the PIIGS are in freefall and have contaminated risk taking and destroyed the US dollar carry trade.

This is in my investment outlook for 2010 (not posted) and will be part of the unravelling of the USD carry/reflation trade of 2009. Currently, I see the S&P bottoming around 990-1020 over the next few weeks before bouncing a little. The real bear action will likely take place later in spring. I believe S&P 666 is going to fall in the second half of 2010, with new highs in the US dollar index.

What does Greece have to do with the Dow? Nothing per se, but the whole world has too much debt (much of it US dollar denominated) and is long risky assets (emerging markets, commodities, stocks). Greece's coming default/restructuring hurts risk appetites and is hurting the Euro and strengthening the US dollar. Since there are too many people with US debt, the rising value of the US dollar hurts those long risky assets. They sell the assets to pay off debt. Mr. Margin doing his magic after taking 2009 off....

Vancouver the biggest bubble in the world.

A new report on world housing is out....

http://www.demographia.com/dhi.pdf

http://ca.news.yahoo.com/s/capress/100125/national/affordable_housing

Toronto housing severely unaffordable.

Montreal housing seriously unaffordable.

This excellent report uses housing prices to median family income as a measure. Now, I acknowledge that this measure does not take into account different tax policies, interest rates, demographics, weather, etc… However, big picture, this is an excellent tool to use.

In fact, Canada has poor tax policies, already rock bottom interest rates, poor demographics, tons of available space (we have one of the lowest population densities in the world), mediocre demographics, and poor weather in the opinion of most people.

If you adjusted these values to reflect these factors, our rating would be even worse. For example, the US has lower tax rates and a mortgage tax deduction, less available space, better demographics and better weather.

The report also has some unconventional thoughts on high-density versus low-density urban planning. This is beyond my area of expertise, so I will not comment, although I do like unconventional thinking, and moving back to the suburbs from the city, their arguments have a sympathetic ear in this blogger.

I take some issue with the report`s argument that the reason that many markets are unaffordable is land use policy (which roughly corresponds to supply). This is definitely a factor. However, the more important factor is that we are currently in a mammoth housing bubble. This bubble was caused by many factors, and land use policy is likely a minor factor in my view. The bubble was caused by a great credit boom that has spanned generations. Housing was (and still is, in Canada) psychologically deemed to be a safe investment that can not lose money. It is perceived to be the best investment class, despite little long term proof of that hypothesis. Over a decade or two, housing can be a good investment, but from today`s nosebleed levels, housing (or any other nosebleed asset class) is doomed to be a poor performer for years, and more likely, for decades.

By taking a snapshot at any given moment, we can make a determination (as this study does quite well) regarding whether housing is affordable or not. However, without the fullness of time or a full market cycle, it is nearly impossible to make reliable conclusions.

I believe that once the housing bubble in Canada deflates, it will bring housing prices back in line with affordability. In fact, periods of overvaluation are usually followed by periods of undervaluation. This same study done in 2000 or 2020 would yield very different results, and if it does, I doubt it will be because land use policies have changed materially.

I had suspected that Australia and Canada had the two biggest housing bubbles left in the so-called developed world. This report backs up this suspicion. Almost all other countries (UK, US, Spain, Ireland) have seen their bubbles deflate or start to deflate.

What do Australia and Canada have in common? Both are commodity countries.

The commodities and risk trade that reflated in 2009 (partly retracing the 2008 losses), has allowed Australia and Canada:

1. Strong export pricing which has lead to
2. Strong asset inflows and currency appreciation which has lead to
3. Low interest rates (as inflation is not an issue in this deflationary environment) which has lead to
4. “Relatively” mild recessions and relatively low unemployment which has lead to
5. No bursting of the housing markets (unlike the non-commodity housing bubbles)

I missed the call on Canadian housing in 2009, but I believe that both Australia and Canada will play catch-up in the coming years:

Why?

6. The commodity deflation and recession will restart in 2010 which will lead to lower export pricing and lower exports
7. Strong asset outflows and currency depreciation which could lead to
8. Higher long term interest rates as sovereign risk worries kick up (Not 100% sure about this one as the deflationary headwinds are quite strong)
9. “Relatively” severe recessions and relatively increasing unemployment (due to point 6)
10. A bursting of the housing markets as unemployment rises and personal savings increase and the same debt retrenchment that has happened in the US shows up in the Great White North.

The fact that Canada had a sharp recession in 2008/9 without its housing bubble and only a partial deflating of commodity prices is very worrisome for the next leg down.

Euroland Crisis

We had a mini-currency crisis in late 2008/early 2009, when many currencies (Canada included) dropped about 20%+.

This currency crisis turned out to be relatively benign in most cases, not all, since it was accompanied by a credit crisis. The deflationary impact of the credit crisis and falling commodity prices meant that this currency crisis was actually welcomed by many countries, as it cushioned some of the impact of deflation. The massive collapse in global trade meant that many countries welcomed the falling currency.

Take Canada: Our loonie dropped to 77 cents, approximately 20 cents down from its summer 2008 levels. The Bank of Canada and many exporters were happy with this currency devaluation since it gave a temporary cost advantage to Canadian exports. In a normal situation, a 25% drop in the loonie in 2 months, may have called for emergency measures, including rate increases and would have caused the inflation rate to increase.

Despite the worries about Greece, the Euro remains quite high at $1.45, off from its $1.60 from 2008 and $1.51 in late 2009.

Why do we care about Europe? Besides being a huge economy that rivals the US, depending how you measure it, it has another impact. The Euro is 57% of the widely followed US Dollar Index (this weighting makes little sense but I digress).

A large drop in the Euro in the summer of 2008 preceded the Crash of 2008 by about a month. The Euro fell and so did commodities (as they are often correlated). At first, misguided bulls claimed that this was good as they wanted $147 oil to come down and lead the way out of the slowdown (what recession?). The Euro was dropping like a rock (from 1.60 to 1.45 from mid July to Labor Day). Pundits at the time claimed that this was because the European economy was slowing and rates were going to fall. Whatever, the reason, the rise in the US dollar was powerful and part of a cycle of a rising US dollar and falling asset prices. There is a ton of US debt out there, and when the US dollar rises, it makes that debt more expensive. Especially in 2010, the US dollar is a funding currency with 0% interest rates.

I believe that the Euro currency never made sense but needed a crisis to show this. The logic of the Euro is the following:

The strong countries (Germany, France) benefit since they no longer have to worry about the so-called PIGS (Portugal, Italy, Greece, Spain) devaluing their currencies against them, which would hurt their huge export driven economies. The PIGS and others benefit since they can easily borrow in a stable currency, the Euro, and hence, at lower interest rates. Win-win.

The problem: To greatly simplify, the PIGS took advantage of the lowest interest rates in their lifetimes to run up debt and in some cases, pile into housing. PIGS have lower standards of living, higher debt loads and higher inflation and yet a one size fits all currency and interest rate structure was the prescription.

The less efficient PIG economies have no way out of the current recessions. They can't cut interest rates (they are already near zero), they can't devalue anymore and most importantly, they can't spend their way out (the EU has strict rules on deficits, and these countries have massive structural deficits and looming funding problems). They have to do the opposite: cut spending and get their house back in order, which is a sure-fire recipe for union troubles, riots and social unrest, not to mention instant dismissal at the polls. The Euro is very unpopular as the cost of living in Euros is expensive in these countries.

The EU is not a country and as such, there is no national identity, no mechanism for bailouts between countries nor are there any transfer payments between countries.

Greece will be the test case, as they need to borrow over 50 billion Euros in 2010 and it is possible that they will not be able to do it via the bond market. If so, they may need to go to the IMF or the EU. If they do, they will likely be forced to impose draconian (by European standards) cuts to social programs. In addition, they will set the precedent for the other weak links. Are hurting taxpayers in Germany going to send money to Greece? In a country like Canada, there is a system for transfer payments between provinces. The EU has no such system. An IMF bailout would be a big black eye for an EU country.

I can't profess to know how this will play out. I do know that even if Greece dodges a bullet right now, there are too many holes in the EU dam that are leaking. Greece may be forced to go for some type of bailout as it would give political cover for the draconian cuts. However, it could start a run on other countries such as Spain (huge housing bubble and unemployment rate) and spill over to non EU countries such as Latvia. The EU could even decide to expel Greece if it deems that it does not have the ability to bail out member countries.

The timing is tricky (doesn't have to happen in 2010) but I don't think the Euro stays at its lofty levels. I believe that the Euro will not go away, but its luster will fade and investors will crave the security of the safe US dollar.

The next part of this bear market will involve currencies and sovereign debt concerns, I believe. And this currency crisis will involve the big guys (Euro and Yen- more on that one another day).

We are at a pivotal point for the US dollar and the Euro. A strong move that started 6 weeks ago, from 1.51 to 1.42 has now consolidated to 1.45. If the US dollar is truly in a bull market, it needs to move higher from here. Thus far, the S&P has shrugged off the higher USD, as it did for about 6 weeks back in 2008 before all hell broke loose.

My target for the Euro is $1.25 this year, but a move to $1 can not be ruled out if a 2008 crash develops this year or if we get some domino action (Greece, followed by someone else and with spillover to the usual suspects of Ukraine, Latvia, Iceland, Ireland, Hungary, etc...).

Disclosure: Position in USD, Euro, CAD