Markets Insight
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April 19, 2012 6:09 pm
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Draghi’s remedy must not become a panacea
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By Pierre Lagrange


Quantitative easing is a magic remedy, at least in the short term. Central bankers can conjure up money out of thin air and use it to purchase assets. Such activity has the capacity to transfer toxic debt, stimulate demand for risk assets, devalue currencies – thus deflating debt – and maintain low interest rates on government securities.



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The European Central Bank’s more restrictive mandate does not allow it to print money for any other purpose than lending, so QE is out of the question. Mario Draghi can therefore be said to have demonstrated the new resolve of the central bank under his leadership in unveiling his longer-term refinancing operation programme within eight weeks of taking office. As we have seen in the case of Hong Kong in 1998 and Switzerland in 2011, decisive central bank intervention sends a message to the markets that there is a willingness to do whatever is necessary.

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Conversely, earlier ECB bond purchases were an indication of wobbly resolve which caused the markets to gorge on negativity. LTRO has therefore transformed a soft belly into a six pack, but more exercise is needed.

 

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Structural issues that are key to longer-term survival need to be addressed while the artificial support of central bank liquidity is in place. Otherwise LTRO will simply prove a case of throwing good money after bad.




A further aspect of LTRO is that it ingeniously makes use of the Basel II accounting rules which place a capital charge of zero on the debt of sovereign nations in the European Economic Area.



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Consequently, the ECB can lend unlimited quantities of funding to European banks, at a nominal interest rate, knowing there is more than one incentive for these banks to purchase government debt.


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Firstly, they can make easy profits from capturing the differential between the interest charged on the borrowed money and the yield on the government debt. Secondly, they can bolster their balance sheets from a regulatory perspective. Moreover, the banks help achieve one of the critical aims of QE in maintaining low borrowing costs for indebted governments.



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Furthermore, LTRO has provided a timely boost to banks in their attempts to raise capital to satisfy an increasingly penal regulatory agenda. The launch of the programme came just four days before the deadline for banks to submit plans for raising the cash needed to maintain capital adequacy levels.



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In providing a temporary resolution to the critical issue of liquidity, LTRO afforded us the opportunity to take a much more structural view of bank fundamentals and pricing dislocations. We have therefore been able to invest with a degree of conviction and to size positions in accordance with proximity to objective target prices.




Nevertheless, a boost in liquidity, like most pharmaceutical drugs, only works effectively in conjunction with complementary measures. Apart from the examples of UniCredit, whose rights issue had been decided before, and Sabadell, we have seen little equity capital raised. This contrasts with the example set by the US in March 2009, which used the Fed-inspired rally to launch gazillions of equity. Central bankers will be again solicited to control markets, testing governments’ resolve.



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In terms of further LTRO usage, we envisage trouble from the fact that most Spanish debt raised has been bought by domestic banks, and that cross border confidence has not been boosted for long.


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Indeed, the data suggest that foreigners have used this window to divest from Spanish government bonds, and the domestic banks have been left mopping up the inventory, albeit with an attractive carry.


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There is increasing evidence that most of the monies from the LTRO have been spent or earmarked, more quickly than the markets thought. Central bankers will soon find themselves needing to buy government debt in the secondary market to prevent rates rising excessively in the periphery. How they do it and what it leads to is important. There is a variety of tools they can use, from securities market programmes (SMP) to relaxation of haircuts. They can also allow Spanish banks to issue government guaranteed debt, essentially creating ECB eligible collateral, similar to what Italian banks have been able to do. SMPs were stopped after the LTRO, but can be reactivated, we hope sooner rather than later. Markets need to understand central banks will not let rates spiral out of control.


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This summer has the added volatility of important elections in Europe, as well as distractions from football to the Olympics, that increase risks of spikes on low volumes. Market interventions will need to be more stringent as a consequence.



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Theoretically there are few limits to what the ECB can do. We will test market limits as investors look through temporary fixes, and political limits such as how much money the ECB can effectively create. This will test the resolve of politicians and central bankers from the north.



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Pierre Lagrange is a co-founder of GLG, chairman of Man in Asia and a portfolio manager



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Copyright The Financial Times Limited 2012.


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04/19/2012 04:08 PM
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French-German Relations
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What a Hollande Victory Would Mean for Merkel
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By Veit Medick and Severin Weiland

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German Chancellor Merkel has made it clear that she would like to see French President Nicolas Sarkozy win a second term. Indeed, if his challenger François Hollande emerges victorious in the country's upcoming election, she could face isolation in Europe. But a Sarkozy re-election might be problematic, too.



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As Europe continues to integrate both economically and politically, the outcomes of national elections have grown in importance to reach beyond their own borders. German Chancellor Angela Merkel knows that, and it's why she will travel on Sunday to Paris, where voters will be heading to the polls in the first round of the French presidential elections.


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Conservative French President Nicolas Sarkozy is fighting for a second term, but he has a strong opponent. The Socialist candidate, François Hollande, has a good chance of moving into the Élysée Palace. The latest polls show Hollande leading in the first round of voting, as well as in the possible run-off vote on May 6.



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For Merkel, this is an election like no other, and one that is even more important to her than many German state elections. Whoever wins in France will help drive European policy by her side. If the victor proves to be Hollande, who differs with Merkel's closely allied partner Sarkozy on many issues, not the least of which involve rescuing of the euro, things could become uncomfortable for her, both in Brussels and at home in Berlin.

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Ripple Effects in Germany


.The election in France could even alter the political landscape ahead of Germany's upcoming federal election in 2013. The center-left Social Democrats (SPD), who are trailing the chancellor in recent polls, desperately need a boost. If Hollande were to win, it would send a signal that social democracy in Europe, and in Germany, is still a force to be reckoned with. That's how party members see it, at least.


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But Merkel's center-right coalition, made up of her conservative Christian Democratic Union (CDU) and the pro-business Free Democratic Party (FDP), hopes that Sarkozy will win in the end. "If that were not to be the case, then the government would have a large problem because, without him, the most important partner for the euro's stability would be lost," says Alexander Graf Lambsdorff, chairman of the FDP in the European Parliament. He says Hollande stands for an "out-dated type of social democratic policies -- more government spending, more public positions and possibly more debt."



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Merkel agrees. That's why she has so strongly backed Sarkozy. What was once a cool relationship between two different types of politicians has grown into a true partnership. During the euro crisis, above all, the two leaders have proved their reliability to each other. Without Merkel and Sarkozy, it is clear that there would not have been a rescue package.


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A Predictable Partner



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Despite their differences, Sarkozy has been predictable for Merkel. Although, if Sarkozy were to be reelected, he would likely savor his victory, having achieved something she still has in front of her.


.Chancellery insiders suspect that Sarkozy would act differently after his reelection, possibly shifting the balance of power in his favor. Whether the Frenchman would then still be inclined to consider German sensitivities is questionable. In Berlin, there has recently been concern over Sarkozy's campaign promises to use the European Central Bank (ECB) more for economic growth policies, which is considered a dangerous venture by Merkel's government.



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But a win by Hollande would be even trickier for Merkel. His statements suggest that he would immediately do away with the austerity measures that Merkel has pushed through in Europe. He has called for more stimulus measures for crisis countries, instead. The EU fiscal pact is the "worst enemy" of the European people, he says. If the treaty is not expanded, he would recommend to the French National Assembly that it not be ratified, he told the German business daily Handelsblatt.



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Can Merkel and Hollande work together? The chancellor has given the Socialist candidate the cold shoulder for a long time but, in the meantime, her aides have carefully put out feelers.


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Hollande has responded by saying that, if elected, his first trip would be to Germany. The EU needs a German-French partnership during its deep crisis, he says.



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Elmar Brok, a CDU politician and the chairman of the European Parliament's committee on foreign affairs, agrees. He maintains that German-French relations have never been especially influenced by the party affliations of the two countries' leaders. "Experience shows that other issues become more important, such as whether there is chemistry between the main players," he says.



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In Brok's opinion, a partnership between Merkel and Hollande is possible. In the end, the conservative French President Giscard d'Estaing and the Social Democrat Chancellor Helmut Schmidt worked as closely together as the Socialist Francois Mitterrand did with Christian Democrat Helmut Kohl.


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Dangerous Policies




But Hollande's policies could prove dangerous for Merkel's coalition. Hollande supports euro bonds, which Merkel has rejected and which could possibly mean the end of her coalition with the business-friendly FDP. He has also made some social promises at odds with Merkel's policies. He calls for a retirement age of 60 and for millionaires to pay a tax rate of 75 percent.


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Those policies are unimaginable in Germany, where even the SPD has problems with them. Still, Merkel's opponents expect a lot in the event of the Socialist candidate's victory. Someone who would most like to see Sarkozy face early retirement is SPD chair Sigmar Gabriel. The exuberant party leader from the state of Lower Saxony may have little in common with the more staid Hollande, but he can build on how the French candidate designed his campaign -- left-leaning, polarizing and in stark contrast to Sarkozy on taxes, social issues and European policies. In some ways, it is how Gabriel imagines his own campaign.



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Gabriel's calculates that, with a Socialist president in Paris, Merkel is more vulnerable. For example, one could be more assertive in the dealings on the fiscal pact, and it would also be easier to take a stronger position on tax and social issues. After all, if a social democrat enjoys success after pursuing a strong path of opposition in Paris, then why not in Berlin?



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Internal Battles



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But the election in France could also pose problems for the Social Democrats in Germany. For one thing, they know that a Hollande victory is not yet secure, and that a win by him could also set off internal battles within the German party. The left wing of the party, for example, would push for social policies more in line with the French, something pragmatists in the party -- such as Frank-Walter Steinmeier and Peer Steinbrück -- want to prevent.



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Merkel's coalition, meanwhile, is remaining cautious. CDU parliamentarian Philipp Missfelder says that the race remains open and will "go down to the wire." The results will not change German-French relations, he adds.



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CDU politician Brok takes a rational view of Hollande's promises. It took Socialist Francois Mitterrand a year and a half after being elected president to distance himself from his left-wing policies, he says. Hollande wouldn't have that much time if he wins, Brok says. "He would have the time between the election and taking office to explain what his position in the European financial crisis is," Brok says. "That is how much leeway he has."


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And Lambsdorff, from the FDP, says: "One can only hope that, in the end, Hollande will also be sobered by France's real economic situation."

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Special report: Manufacturing and innovation
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A third industrial revolution
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As manufacturing goes digital, it will change out of all recognition, says Paul Markillie. And some of the business of making things will return to rich countries
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Apr 21st 2012




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OUTSIDE THE SPRAWLING Frankfurt Messe, home of innumerable German trade fairs, stands the “Hammering Man”, a 21-metre kinetic statue that steadily raises and lowers its arm to bash a piece of metal with a hammer. Jonathan Borofsky, the artist who built it, says it is a celebration of the worker using his mind and hands to create the world we live in. That is a familiar story. But now the tools are changing in a number of remarkable ways that will transform the future of manufacturing.



One of those big trade fairs held in Frankfurt is EuroMold, which shows machines for making prototypes of products, the tools needed to put those things into production and all manner of other manufacturing kit. Old-school engineers worked with lathes, drills, stamping presses and moulding machines. These still exist, but EuroMold exhibits no oily machinery tended by men in overalls. Hall after hall is full of squeaky-clean American, Asian and European machine tools, all highly automated. Most of their operators, men and women, sit in front of computer screens. Nowhere will you find a hammer.

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And at the most recent EuroMold fair, last November, another group of machines was on display: three-dimensional (3D) printers. Instead of bashing, bending and cutting material the way it always has been, 3D printers build things by depositing material, layer by layer. That is why the process is more properly described as additive manufacturing. An American firm, 3D Systems, used one of its 3D printers to print a hammer for your correspondent, complete with a natty wood-effect handle and a metallised head.




This is what manufacturing will be like in the future. Ask a factory today to make you a single hammer to your own design and you will be presented with a bill for thousands of dollars. The makers would have to produce a mould, cast the head, machine it to a suitable finish, turn a wooden handle and then assemble the parts. To do that for one hammer would be prohibitively expensive. If you are producing thousands of hammers, each one of them will be much cheaper, thanks to economies of scale. For a 3D printer, though, economies of scale matter much less. Its software can be endlessly tweaked and it can make just about anything. The cost of setting up the machine is the same whether it makes one thing or as many things as can fit inside the machine; like a two-dimensional office printer that pushes out one letter or many different ones until the ink cartridge and paper need replacing, it will keep going, at about the same cost for each item.




Additive manufacturing is not yet good enough to make a car or an iPhone, but it is already being used to make specialist parts for cars and customised covers for iPhones. Although it is still a relatively young technology, most people probably already own something that was made with the help of a 3D printer. It might be a pair of shoes, printed in solid form as a design prototype before being produced in bulk. It could be a hearing aid, individually tailored to the shape of the user’s ear. Or it could be a piece of jewellery, cast from a mould made by a 3D printer or produced directly using a growing number of printable materials.




But additive manufacturing is only one of a number of breakthroughs leading to the factory of the future, and conventional production equipment is becoming smarter and more flexible, too.



Volkswagen has a new production strategy called Modularer Querbaukasten, or MQB. By standardising the parameters of certain components, such as the mounting points of engines, the German carmaker hopes to be able to produce all its models on the same production line. The process is being introduced this year, but will gather pace as new models are launched over the next decade. Eventually it should allow its factories in America, Europe and China to produce locally whatever vehicle each market requires.



They don’t make them like that any more



Factories are becoming vastly more efficient, thanks to automated milling machines that can swap their own tools, cut in multiple directions and “feelif something is going wrong, together with robots equipped with vision and other sensing systems. Nissan’s British factory in Sunderland, opened in 1986, is now one of the most productive in Europe. In 1999 it built 271,157 cars with 4,594 people. Last year it made 480,485 vehiclesmore than any other car factory in Britain, ever—with just 5,462 people.



“You can’t make some of this modern stuff using old manual tools,” says Colin Smith, director of engineering and technology for Rolls-Royce, a British company that makes jet engines and other power systems. “The days of huge factories full of lots of people are not there any more.”



As the number of people directly employed in making things declines, the cost of labour as a proportion of the total cost of production will diminish too. This will encourage makers to move some of the work back to rich countries, not least because new manufacturing techniques make it cheaper and faster to respond to changing local tastes.



The materials being used to make things are changing as well. Carbon-fibre composites, for instance, are replacing steel and aluminium in products ranging from mountain bikes to airliners. And sometimes it will not be machines doing the making, but micro-organisms that have been genetically engineered for the task.




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Everything in the factories of the future will be run by smarter software. Digitisation in manufacturing will have a disruptive effect every bit as big as in other industries that have gone digital, such as office equipment, telecoms, photography, music, publishing and films. And the effects will not be confined to large manufacturers; indeed, they will need to watch out because much of what is coming will empower small and medium-sized firms and individual entrepreneurs. Launching novel products will become easier and cheaper. Communities offering 3D printing and other production services that are a bit like Facebook are already forming online—a new phenomenon which might be called social manufacturing.



The consequences of all these changes, this report will argue, amount to a third industrial revolution. The first began in Britain in the late 18th century with the mechanisation of the textile industry. In the following decades the use of machines to make things, instead of crafting them by hand, spread around the world. The second industrial revolution began in America in the early 20th century with the assembly line, which ushered in the era of mass production.



As manufacturing goes digital, a third great change is now gathering pace. It will allow things to be made economically in much smaller numbers, more flexibly and with a much lower input of labour, thanks to new materials, completely new processes such as 3D printing, easy-to-use robots and new collaborative manufacturing services available online. The wheel is almost coming full circle, turning away from mass manufacturing and towards much more individualised production. And that in turn could bring some of the jobs back to rich countries that long ago lost them to the emerging world.


Why Wall Street Can't Escape the Eurozone

April 19, 2012
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By Keith Fitz-Gerald,
Chief Investment Strategist, Money Morning




Despite all of its best hopes, Wall Street will never escape what's happening in the Eurozone.

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The 1 trillion euro ($1.3 trillion) slush fund created to keep the chaos at bay is not big enough. And it never was.

.Spanish banks are now up to their proverbial eyeballs in debt and the austerity everybody thinks is working so great in Greece will eventually push Spain over the edge.

.Spanish unemployment is already at 23% and climbing while the official Spanish government projections call for an economic contraction of 1.7% this year. Spain appears to be falling into its second recession in three years.


I'm not trying to ruin your day with this. But ignore what is going on in Spain at your own risk.

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Or else you could go buy a bridge from the parade of Spanish officials being trotted out to assure the world that the markets somehow have it all wrong.
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But the truth is they don't. EU banks are more vulnerable now than they were at the beginning of this crisis and risks are tremendously concentrated rather than diffused.


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You will hear more about this in the weeks to come as the mainstream media begins to focus on what I am sharing with you today.

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The Tyranny of Numbers in the Eurozone


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Here is the cold hard truth about the Eurozone.

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European banks reportedly will have more than 600 billion euros ($787 billion) in redemptions by the end of the year. They come at a time when the banks have sustained billions in capital losses they can't make up.

 .Worse, they've borrowed a staggering 316.3 billion euros ($414.9 billion) from the ECB through March, which is 86% more than the 169.8 billion euros ($222.7 billion) they borrowed in February. This accounts for 28% of total EU-area borrowings from the EU, according to the ECB.


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There will undoubtedly be more borrowing and more losses ahead as interest rates rise further.
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The process will not be pleasant:

  • Credit default swap costs will rise, pushing debt yields to new highs while at the same time making fresh Spanish debt cost-prohibitive;

  • The Spanish government will force national banks to buy debt at higher rates, triggering capital losses on their bonds;

  • Those same losses will trigger margin calls, forcing banks to unload segments of their debt and equity portfolios;

  • Rinse and repeat steps 1-3 until there is no more money, the public revolts, the EU splinters, or all three.

Unfortunately, this vicious cycle is already under way.

The Big Boys Go on the Offensive


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On Monday, Spanish 10-year bond yields pushed up to 6.07%. (Yields and prices go in opposite directions. If one is rising, the other is falling.) They relaxed slightly on Tuesday, but...
 

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At the same time, Spanish credit default swaps touched record levels, reaching 502.46 basis points according to Bloomberg News. That process actually began in February when traders starting upping the ante on Spanish debt.
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Spanish Debt

Figure 1: Source: Bloomberg.com - CSPA1U5: IND


Credit default swaps pay the buyer face value if the borrower - in this instance Spain - fails to meet its obligations, less the value of the defaulted debt. They're priced in basis points. A basis point equals $1,000 on each $10 million in debt.

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Wall Street sells them as insurance against default.


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In reality though, they are like buying fire insurance on your neighbor's house in that you now have an incentive to burn it down.
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Let me briefly explain how the playbook works.

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The big boys are going on the offensive and pushing the cost of insuring Spanish debt to new highs because they know that the Spanish government prefers more bailouts to pain. It's the same thing they did with Greece, Ireland and Italy.

At the same time, they're shorting Spanish debt knowing full well that there will be massive capital losses as Spanish bonds deteriorate.
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What these fiscal pirates are counting on is the ECB and Spanish government riding to the rescue.
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At that point, they will sell their swaps and go long Spanish bonds, thus netting themselves a two-fer.
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How to Play the Eurozone Crisis


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This could be a good thing for savvy individual investors-- at least temporarily.
 
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The markets have become addicted to bad news. We cheer when central bankers step in with quantitative easing, conveniently forgetting things are so terrible we "need" it in the first place
 
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We'd rather take one more "hit" than step away from the narcotics of cheap money.


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That's why I expect a rally when the ECB is forced to step in no later than Q3 2012.

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Here's what to do ahead of time:

  • Buy volatility when it's low. My favorite choices are either call options on the VIX or the iPath S&P 500 VIX Short Term Futures ETN (NYSE: VXX), an exchange-traded note that effectively tracks the VIX. This will help you capture the initial downturn while also taking the sting out of your broader portfolio. At 18.85 the VIX is not as low as I'd like to see it, but not a bad entry point, either. If the VIX drops to 12-15, that's the time to be very interested in this trade.
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  • Sharpen your pencils and pick up shares of large "glocal" companies when they get put on sale in the months ahead. Many will actually use the downdraft to solidify their competitive positions and be stronger on the other side.

  • Gold and silver are going to get whacked. This is not a problem for those with a longer term perspective - both metals are likely to be sharply higher in the years ahead. However, in the shorter term, gold is likely to trade down sharply as banks raise cash. I'll be looking to $1,500 or so as line in the sand. Silver's retracement will be more nuanced because it is a function of the perceived drop in industrial usage that will accompany an EU disintegration. In that sense it won't be as deep or probably as steep. I see $20-22 as a very attractive price.

  • Short the euro. Go long German Bund futures and bonds. According to Bloomberg, the June 10-year bund futures contract is 140.43, or slightly below the record 140.51 it hit recently.

  • Buy U.S. dollars. Longer term, they still stink but the world will run to them once again when the stuff hits the fan.

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At the end of the day, thinking about all this is no fun. I know - I get paid to do it every day. When the fundamental environment is such a wreck, it can wear on you. It certainly does on me.

But you know what?

.That's not actually so bad, because big down days are actually profits in the making;
it's how you deal with them that makes the difference.