The case for going long the Dollar & short the Euro

The guardian of the single currency, the European Central Bank (ECB), has been taking on more and more bad debts from its failing member states – a situation that looks increasingly bearish for the single currency. Meanwhile a rally in the US Dollar is long overdue and the two circumstances may present a decent opportunity for investors.

Troubled Euro

A recent article in German newspaper Der Spiegel reveals the extent of the toxic assets building up on the balance sheet of the European Central Bank (ECB). Financial guarantees at the bank now total €2000 billion in asset-backed securities, public sector and corporate bonds, bank bonds and other securities.

According to Der Spiegel “no one really knows how high the central bank’s risk is in the crisis-ridden countries of Portugal, Ireland, Greece and Spain” but statistics from the Bundesbank provide an indication of just how bad the situation is. These four countries (the so-called PIGS) have combined liabilities of €343.1 billion, the highest in the ECB system.

The ECB is a dumping ground for bad loans, and when the banks in one of its member countries go bankrupt, the euro countries must step in and collectively cover any losses. Germany’s central bank, the Bundesbank, has to provide 27% of the ECB’s capital, which means that they would have to cover more than a quarter of any losses. The bank has set aside reserves of €4.9 billion to cover possible risks but the failure of Greece alone would cost the German bank €12.69 billion.

The risks extend beyond toxic government bonds however. The ECB also has huge exposure to asset-backed securities (ABS) the financial instruments at the heart of the US real estate debacle that caused the global financial crisis. According to the Association for Financial Markets Europe (AFME), the total value of all outstanding asset-backed securities in the euro zone and the United Kingdom is €1.8 trillion. Not all the asset-backed securities taken on by the ECB are toxic, but those from peripheral countries like Greece or Ireland are often of questionable value.

With the European debt crisis gathering pace it’s only a matter of time before these loans are exposed as being significantly under collateralised – a scenario that will likely trigger dumping of the single currency and a flight to the relative safety of the US dollar.

Dollar reversal due

The US dollar has been in a down-trend since February 2002. Historically the dollar moves in any one direction for around 5-6 years, only on one previous occasion did a cycle extend as long as 9 years, so the dollar is definitely due a reversal.

Despite the fact that its latest rally looks to have failed – it’s back below the 50-day moving average on the dollar index – I believe the world’s reserve currency could move considerably higher in the coming months and I’m not the only one.

Dennis Gartman of the Gartman Letter, one of the most widely followed and celebrated commodities traders around, is also bullish on the buck. In a recent interview Mr Gartman explained that many investors are still “egregiously and preposterously” short US dollars. In particular he believes that the dollar with strengthen against the Euro, “The trend is toward a much weaker euro and a much stronger dollar over time,” he says.

A rise in the dollar above 77 could trigger short covering that would propel the currency quickly higher.

Those looking to play the move could look at the Short EUR Long USD ETF from ETF Securities (SEUR). Another option is the UltraShort Euro ETF from ProShares (EUO) which tries to provide twice the daily inverse performance of the euro against the US dollar.

Alternatively investors could just look to go long the Dollar Index since it’s heavily weighted towards the Euro.

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