Whenever there’s a risk of devaluation, the direction of risk seems to go in one direction only. Soros knew this when he famously bet against the pound in 1992 and “broke the bank of England.” As the German Bundesbank increased interest rates to fight an inflationary valuation of East German marks after unification, the British pound came under intense pressure. Speculators doubted the Bank of England’s ability to keep pace with the Bundesbank in enforcing a tight monetary policy during a worsening recession. This left Soros with a one-way bet. The pound would either stay in the exchange rate mechanism (and hug the value of the DM) or devalue considerably if the Bank of England lacked the political will to keep up with Germany’s anti-inflationary policies. Soros either wins or ties.
Is there such a trade today with the European periphery vs. the center? A similar situation exists in that Greece, Italy, Spain and Portugal are following the European Central Bank’s too-tight monetary policy. It’s likely that the southern central banks would have devalued and inflated long ago, with beneficial affects for exporters, debtors and overall aggregate demand. It even seems like, with the election of Syriza (Italy, Spain & Portugal also have their disenchanted leftists waiting to take charge), the political will to keep the Euro has been called into question.
For simplicity, let’s assume there are two blocks, a strong-Euro block (led by Germany, Netherlands, Finland, Austria) and a weak Euro block (led by Italy, Greece, Portugal and Spain). The strong Euro block is skeptical about QE, doesn’t want to debase the currency, is very fearful of inflation. The weak Euro block is suffering from depression-level unemployment, increasing poverty, uncompetitive exports and increasing political pressure to just do something.
It seems we have a classic one-way-bet scenario because the weak-Euro block’s currency is tied directly to the strong-Euro block’s central bank policies. If anyone is going to devalue, it’s going to be Greece-Italy-Spain-Portugal. They certainly wouldn’t pursue a tighter policy than the ECB. There’s just one problem: the weak block uses the same currency as the strong block. So what one-way bet is there?
The basic premise of a one way bet would be to borrow Greek euros and use the proceeds to buy German euros. The more this happens, the more capital flees Greece, the more political pressure builds to flee the Euro (Grexit becomes reality). Whenever a country faces a decision like Greece, capital always flees. In the United States this happened with the free silver movement in the late 1800’s. As farmers agitated for silver, deflation became more acute as capital fled. The same happened when Britain left the gold standard in 1931. The United States came under speculative attack as the next domino to fall. And of course when the pound fell vis-a-vis the Deutsche Mark.
I’m not an expert in bond market possibilities, but perhaps one way to do this would be to sell insurance on German bonds and buy the same insurance for Greek (or Italian or Spanish) bonds. That way you earn some return on the insurance you sell to pay for the insurance against default that you buy. Also, you could look for companies with a large book value with liquid assets held in Italy or Spain, short sell them while buying call options on similar entities in Germany (or the United States).
The risk (and it’s a big one) is that the European Central Bank has the economic power to bring about recovery in Europe’s periphery. The political will may not exist, but the power does. In a crisis that pitted evil, Anglo-Saxon speculators against humble Greek farmers and business owners, European public opinion would likely sway enough to give the ECB a green light on an easier monetary policy. There would be more QE, more devaluation, maybe even a target for nominal GDP growth (Scott Sumner could declare victory).
So while there may be a way to make this one-way bet, it’s extremely risky to bet against a central bank’s power to inflate it’s own currency. In the end, this becomes a bet over political will.