Contemplating the unthinkable long ago became a necessary tool for analyzing the euro sovereign debt crisis. Today’s failed Bund auction is another step on the road to Berlin. The 1.98% yield is hardly attractive, and one could quite understand investors avoiding such paltry returns for ten years under most circumstances. But the Euro’s uncertain future has done what miniature German interest rates have not, and that is cause a shortage of willing buyers. Only 65% of the offered bonds were desired by private investors, and as a result the Bundesbank became the unwilling holder of over €2.3BN of the €6BN auction. They apparently plan to sell these in the near future when markets are calmer. They probably will – but this episode represents another step towards the cliff with seemingly no clear plan of action from policymakers to turn away from the brink.

The € seemingly has no good options. The best prospect for the currency to strengthen is in the event of a surprising and dramatic plan to solve the crisis. No such event appears plausible, but regardless of that all the likely solutions are negative for the currency:

1) slower growth through the austerity of reduced government budgets

or

2) a compromise of the ECB’s single focus on inflation as it buys unlimited amounts of debt.

And there’s always the possibility of neither of these, which is most likely worse.

The relationship between the € and the S&P500 (SPY) has grown steadily tighter in recent months. The correlation of returns between the S&P500 and the € over the past year is 0.6, whereas over the past month it’s 0.84. The slope of the regression line has gone from 0.27 to 0.4, and the relative volatility has risen from 0.4 to 0.9. In layman’s terms, they’ve become more linked but in addition the € has become increasingly sensitive to moves in the S&P500. What this means is a growing asymmetry between a portfolio of long equities and the main transmission of potential losses, the €. The statistics and our assessment are that a peaceful resolution to the crisis should lead to higher equities and a (perhaps only temporarily),  stronger € whereas a disaster will cause a sharply lower € with weaker equities. There is some positive convexity to owning equities, which are generally attractive long term investments facing huge macro uncertainty, and being short the €. This is our position – long a selection of equities that will still be profitable companies in virtually any scenario  – names such as KFT, MSFT, BRK, and short € through owning EUO.

Disclosure: Author is long SPY, KFT, MSFT, BRK, EUO

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