Why we’re up 30% on our gold/euro position

May 12, 2010
Undisclosed Location

First of all, I really want to thank all the well-wishers who were kind enough to write me and wish me luck on my operation yesterday. Everything went off without a hitch, and I’m already feeling much better.

I will unfortunately need to stay in place for a few weeks while I recover and have a few follow-up visits, but I expect to get airborne again quite soon.

To be honest with you, the place I’d love to be the most right now is Greece. I think history is unfolding right in front of us, and I really want to see it with my boots on the ground.

I thought it was absolutely amazing when European leaders came to the table this week with almost $1 trillion to defend the euro against the market’s siege. Yet, by the end of the day after the initial euphoria had worn off, Europe’s support didn’t register so much as blip in the euro’s strength.

Specifically, after the announcement of the trillion dollar support package, the euro finally closed Monday afternoon at $1.27. Prior to the announcement before the weekend, the euro closed Friday at… $1.27. Not exactly much of a difference.

In other words, the market essentially laughed off the government’s trillion dollar pledge of support. Why? A few reasons-

First, no one really believes the European support truly exists, especially not in that magnitude;

Second, even if it did, investors now finally realize that these politicians are simply playing with their own worthless monopoly money;

Third, and most importantly, anyone with two brain cells to rub together recognizes that Europe’s economic woes cannot be contained with more paper money… and now the problem just became $1 trillion worse.

Battling back from an economic crisis requires hard work, savings, and minimal disruption from the government. There’s no magic pill, entitlement program, or paper money bomb that will suddenly make things better.

Instead, governments should be curtailing social benefits that encourage people to be lazy, while simultaneously stripping taxes to the bare bones in order to give entrepreneurs and investors the proper motivation to work hard, take risks, and hire employees.

These things are not happening, nor will they ever happen in the foreseeable future. And so, backed by Europe’s trillion dollar pledge, Greece will likely go back to business as usual… spending money that it doesn’t have, and making its problems exponentially worse.

Last summer, when I was in Europe, I wrote a short piece about the euro. At the time, I explained why it was overvalued (at around $1.43 back then) and that its fair market value should be in the range of $1.18 to $1.25 to achieve similar parity as the US dollar.

In the past, investors were desperate to dump their dollars, and the euro seemed like the most viable alternative. Investors paid a premium for the euro, bidding the price well beyond its fair market value to as much as $1.60.

Today, the euro is once again trading near its fair market value range that I estimated at $1.18 to $1.25. This is because the market no longer views the euro as a viable alternative to the dollar, hence it is not worth paying a substantial premium to fair market value.

Remember, due to the size of their respective bond markets and relative lack of capital controls, there are only three currencies in the world that have the capacity to absorb large institutional capital flows– the dollar, the yen, and the euro.

If you’re a small investor with a few million dollars, you can park that cash just about anywhere without affecting the exchange rate.

But if you’re a large institution with billions of dollars, only the dollar, yen, and euro can consistently absorb huge inflows/outflows of capital without drastically affecting the exchange rate.

For now, those capital flows are moving out of the euro and into the dollar. The reasons behind the ‘europremium’ are gone, so the purchasing power of the two currencies should be roughly the same.

As such, I would be uncomfortable having a short euro/long dollar position in this range unless there were a very clear signal that the euro’s collapse is imminent.

Since the PIGS have a trillion pieces of paper to burn through for the time being, I expect this won’t happen for some time.

Additionally, for the time being, I’m happy to maintain my short euro/long gold position (XAUEUR) as I continue to believe that institutional funds are starting to shun government bonds in favor of gold. This position has returned us 30% since I first mentioned it a few months ago.