Europocalypse

America may be banged up, but Europe is teetering on the edge of flat-out fiscal disaster... which helps explain the bizarre action in gold and the dollar as of late.

Imagine a postcard-perfect mountain village. A-frame chateaus, old world door crests, cheery gas lamps the kind of place you might see tucked away in the Pyrenees or the Swiss Alps. As a crowning touch, large flakes of snow are gently falling.

Now take a step back. Instead of an actual village, you are looking at the contents of a snow globe.

The snow globe is sitting on the edge of a large oak table.

Now you see the back of a large, well-manicured hand perhaps a bankers hand accidentally sweep the snow globe over the edge of the table. The snow globe hurtles toward the cold marble floor, where it will shatter into a thousand pieces.

What you have just envisioned is a metaphor (or is it analogy, I forget) for Europe. The free fall is happening as I write.

The Horror

If Colonel Kurtz had been a European banker (rather than a deranged flyboy lost deep in the Congo), he would know exactly what to say about Europes fiscal predicament now:

The horror... the horror.

Here are some choice examples of what I mean:

According to a recent Bloomberg story, Germany and France may be forced to contemplate the bailout of entire nations [emphasis mine] rather than just individual banks. A number of European countries are in the tight spot of hosting banks that are not just too big to fail, but potentially too big to bail... meaning the extent of bank losses could outweigh the host countrys GDP.

BCA Research reports that, with Iceland serving as the gold standard of credit risk, the five sovereigns closest to an Icelandic fate are all European: Portugal, Ireland, Spain, Italy and the United Kingdom.

Less than two weeks ago, the UK Telegraph got its hands on a secret Brussels document being circulated among high-profile finance ministers. According to the Telegraph, this highly confidential 17-page report suggests toxic asset bailout estimates as high as 16.3 trillion pounds, or more than $23 trillion U.S. Thats trillion with a T... more than the gross domestic product of all European Union countries combined. The estimate could be reduced by three-quarters and it would still be disaster.

Eastern Europe is enduring its own special circle of forex hell, with the Prague and Warsaw exchanges plumbing multi-year lows. For example, the Polish Zloty has gone into free fall as a result of toxic FX options the currency version of Credit Default Swaps. As the FT Alphaville blog reports, Polish banks flogged these toxic forex derivatives to corporate clients; when the Zloty fell below a certain level, the options triggered a daisy chain of spiraling corporate losses.

The New Odd Couple

The mass carnage unfolding in Europe further explains an extremely odd phenomenon: the bosom-buddy pairing of gold and the dollar.

When new traders get their first taste of the macro landscape You mean this stuff is all connected? Wow! the gold-dollar relationship is one of the first things they learn about.

Gold and the dollar, in short, are supposed to be like matter and anti-matter. When gold is strong, the dollar is generally weak (and vice versa). A steady-eddie greenback represents the triumph of central bankers and the taming of inflation... where rising gold, in contrast, represents bankers folly and the ravages of the printing press. They are north and south, black and white, yin and yang you get the picture.

That long-standing set-up explains why its been just plain weird to see gold and the dollar jointly kicking butt as of late. Both are exploring multi-month highs, as if the tandem climb were the most natural thing in the world. (In my latest Macro Trader briefing, I described the yellow metal and the greenback as The New Odd Couple.)

So how does this tie back in to Europe?

Simple: With an entire continent choking on the equivalent of toxic subprime squared, there are only three obvious places on Earth left for large pools of terrified financial capital to hide gold, the U.S. dollar, and U.S. Treasury bonds. (And guess what... two of those three are booby-trapped!)

Ill admit it. I didnt foresee Europe getting itself into this much trouble. The old world is supposed to be more staid and conservative than the United States in matters of finance at least so whod have thought that nose-in-the-air Brussels types could have layered on enough leverage to make a swaggering Texan blush?

Now What?

So where do we go from here? As I told Macro Trader members more than a week ago, the dollar is a mystery wrapped in a riddle for now. We shifted our trading bias from bearish to neutral on the buck without taking a forex stance either way. There are some currencies we like very much from a longer-term investment perspective, but from a trading perspective its watch and wait.

As for gold which we have been long for weeks in Macro Trader via gold stocks and the metal itself when the stars align, they really align. I think thats the case for the yellow metal now.

To borrow a turn of phrase from an old Market Wizards interview, the sun has moved closer to the Earth and gold is the best zinc ointment money can buy. Greenbacks and U.S. treasuries, the second and third best alternatives in a world where Europe and Japan are imploding, offer broad and deep liquidity but make for seriously lousy sunscreen.

As youd expect, Ill keep an eye on the Europe situation (as well as the many other crazy developments unfolding right now) and keep you posted.

A few of you have also written in to say Hey JL, what about all that gold in the vaults of the IMF and Fort Knox? Arent you worried they might try to dump it on the market?

My answer: Nope, not really. Even if the powers-that-be had the stones to try such a maneuver (which I doubt), it would prove to be a suicide move. Next week Ill tell you why...