Concerns over sovereign debt driving bets against the Euro

Financial markets continue to be roiled this week over fears that a European debt crisis could derail the global recovery. Last week G-7 central bankers discussed the debt problem in Greece – a possible precursor of what may happen in the U.S.  Investors fear Greece may default on its sovereign debt, or require a bailout from already strapped European governments. Paul Krugman, the Nobel-winning Princeton economist writes a brilliant anatomy leading up to the current “mess” in the Eurozone; you can read that here. Along with Greece, concerns are now spreading to other financially troubled governments such as Portugal, Italy and Spain - known collectively as the PIGS of the EU - and perhaps further down the road, the U.S. given the mounting national debt levels.  Fears of sovereign debt contagion across the Euro-zone also sent European markets sharply lower as negative sentiment spread to Wall Street this week pushing the Dow below 10,000 on Monday.  European and UK stock markets fell more than 2%, with Portuguese and Spanish stock markets leading the declines with falls of 5% or more.  Investors also sold their sovereign debt holdings, as well as currency positions in the Euro, in the affected Euro-zone countries and sought the safety of the Greenback and US Treasuries.  The dollar benefited from its current status of the reserve currency of choice, and was up 0.7% against a basket of trade-weighted currencies, its highest level since July of last year. US Treasuries also rallied on a flight to safety.

The latest catalyst for Market jitters is the accumulation of $8 Bn (€5.9 Bn) in short positions by hedge funds and prop desk traders against the Euro – the largest short position against a major currency ever based on fears of a Euro-zone debt crisis. This development is an indication that investors have lost confidence in the Euro-zone’s ability to withstand a wider contagion from Greece’s budget problems to other European economies. This is on top of last week’s failed bond auction in Portugal, which was scaled back due to lack of demand and which has reignited fears that Portugal and Greece will not be able to fund their budget deficits without a bail-out.

Reflecting growing investor concerns, Jean-Claude Trichet, President of the European Central Bank, sought to play down concerns over Greece, saying he was “confident that the Greek government will take all the decisions that will permit [it] to reach” the medium-term goal of cutting its budget deficit. In an expression of confidence, the ECB left its main interest rate unchanged at 1% at its meeting last week. Others have been prodding Greece to approach the IMF for relief as one solution.

President Barack Obama says he wants to double exports over the next five years, supporting 2 million American jobs. The more products we make and sell to other countries, the more jobs we support right here in America,” Obama said in one of the few instances of his State of the Union address last week where he received hearty applause from Republicans and Democrats.

These developments pose a significant threat to short-circuit the budding global economic recovery. Nevertheless, from an economic foreign policy perspective, this is not all that bad for the U.S.  In fact, it may be the proverbial silver-lining, reminding investors in global markets that the Greenback is still king of all currencies when it comes to a flight to quality.  These developments also present greater opportunities to drive increased U.S. exports to Euro-zone countries, as a result of more favorable exchange rates versus the affected countries. Analysts have estimated that every $1 Bn growth in net U.S. exports creates approximately 100,000 new jobs.   Similarly, doubling U.S. exports in five years to create 2 million new jobs was a topic President Obama featured as part of his economic recovery agenda that was widely received by both Parties in his State of the Union address recently.