By Evaldo Albuquerque, Editor, Exotic FX Alert
Central bankers are some of the worst magicians in the world. Unfortunately, they love to use their sleight of hand on our monetary system.
As we saw last week, one of their favorite tricks is to make bad debt disappear.
Remember when all those mortgage securities went bad a couple of years ago? Then the Fed stepped in and waved its magic wand.
A little accounting magic and poof! These toxic mortgage securities disappeared.
But we all know that debt hasn’t really disappeared. It’s sitting right on the Fed’s balance sheet. Nothing has changed. It’s still debt that nobody is addressing.
In the end it’s just a bad magic trick that we all pay for in the long run.
I’m sorry to report the European Central Bank (ECB) is now trying its own hand at making debt disappear.
The good news is this is creating some intriguing opportunities in the currency market. I’ll tell you about them in just a minute. First let’s take a look at the latest magic trick in Europe…
How the ECB is Flushing its Credibility
Down the Toilet
In 1991, Trichet, now the chairman of the ECB, co-wrote the Maastricht treaty that created the EU currency bloc. This means Trichet personally helped write the rules that govern the European Union.
Now he’s throwing that rulebook away.
The treaty prohibits bailouts or any other form of monetary financing of member states. But so far, the ECB has helped bailout Greece, Portugal and Ireland. And the ECB has bought bonds to help finance the broke countries.
Last week, the bank went one step further in breaking its own rules.
Like any central bank, the ECB often gives loans to European banks. When it does, the ECB often takes bonds from debt-ridden countries as collateral. To avoid taking too much risk, the ECB used to require those bonds to have a good credit rating.
But last year the ECB made an exception for Greece. And now it’s doing the same for Portugal.
Last week, the rating agency Moody’s downgraded Portugal’s debt to junk status. Afterwards, the ECB decided to make a change.
Trichet announced the central bank will suspend its minimum credit-rating threshold on Portuguese bonds as well. In other words, the ECB is now prepared to hold more assets that may turn out to be very toxic.
Another Flip-Flop in the Making
Negotiations on how to solve the Greek crisis are still ongoing. At this point, the most probable scenario is that private investors will have to roll over Greek debt. Rating agencies have warned they will treat that as a “selective default.”
The ECB remains opposed to accepting Greek debt if such a “selective default” happens.
Trichet has said many times that the ECB would reject bonds with default ratings as collateral for loans. If he keeps his word, Greek banks will collapse without the liquidity provided by the ECB.
But we all know how much Trichet’s word is worth: not much.
Last year, Trichet said the purchase of government bonds was not an option. Four days later, the ECB started to buy bonds from Greece.
So it’s very likely the ECB will continue to accumulate bonds, even if they have a default rating. The ECB will not pull the plug on the Greek banking system.
And that’s a dangerous game. London- based Fathom Financial Consulting estimates a 70% write-down in Greek debt would cost the ECB about 25 billion euros. Its collateral would take a hit of 20 billion euros.
That’s enough to erase the ECB’s entire capital base.
In other words, when the inevitable Greek default finally comes, the ECB will have so much exposure to these toxic bonds that there is a real chance of it going insolvent.
And let’s not forget that the ECB also holds bonds from Portugal and Ireland.
What Does it All Mean to You?
Even if you don’t live in the EU, this has major implications for the currency markets.
Now does this mean the euro is finished? Not really. Remember, the Forex market is a relative game. So it really depends what you measure the euro against.
In the past year, for example, the euro appreciated 13% against the dollar. But it lost 10% against the Swiss franc, and nearly 4% against the Norwegian krone.
With the European debt crisis going on, a lot of people don’t understand why the euro can be so strong against the dollar. But to understand why that is, you just have to look at the last three words of the previous sentence.
It’s only strong against the dollar.
As an investor, this gives you the opportunity to buy the currencies that are beating out both the dollar and the euro, like the Swiss franc and Norwegian kroner.
Also, the fact the ECB is losing credibility is very good news for another currency: gold. It has gone up almost 15% against the euro over the past year.
Gold has also been pretty stable lately, despite the correction in other commodities. It just shows how the yellow metal is behaving much more like a currency than just a commodity.
As this euro mess plays out, gold will be yet another currency in the best place to profit – particularly if the ECB runs out of cash on its books.
Bottom line: the ECB will do whatever it takes to avoid a major crisis, even if it has to hold toxic bonds that may turn out to be worth as much as toilet paper. For you, this is a great opportunity to load up on gold and other sounder currencies, such as the Swiss franc and Norwegian Krone.
Best Regards,
Evaldo Albuquerque
Editor, Exotic FX Alert
Source: The Sovereign Investor