Which will crack first, the euro or the dollar?

The arrest of Dominique Strauss-Kahn is just the latest problem to hit the euro. But with the US set to hit its debt ceiling, the dollar faces serious challenges too. What does this mean for investors? John Stepek takes a look.

The papers this morning are full of the news of the arrest of Dominique Strauss Kahn, managing director of the International Monetary Fund (IMF).

Strauss-Kahn was arrested in New York after allegedly attacking a maid in his hotel room. He denies all charges.

We'll not delve into the details of the story here. But his arrest comes at a very sensitive time for the markets.

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Strauss-Kahn was meant to be attending a meeting of eurozone finance ministers in Brussels today, to discuss among other things, the fate of Europe's weakest link Greece.

It's not a killer blow. But it certainly won't make things any easier.

The eurozone yet another worry for markets

It's been a rocky few weeks for markets.

Concerns about a slowdown in China, and the end of quantitative easing in the US have weighed on commodities, as we discussed in Money Morning on several occasions last week.

But there's another big worry that's also been nagging away at markets. It's a recurring nightmare that just won't go away. Yes, we're talking about Europe.

Up until the last couple of weeks, investors had been happy to pretend that everything was going to be just fine in the eurozone. It would muddle through somehow. And besides, the European Central Bank (ECB) was raising interest rates, so things couldn't be that bad.

But then the ECB indicated that it wasn't quite as keen to raise rates as everyone had thought. That sent the euro sharply lower. And now the market has remembered that the original deal to bailout Greece, agreed last year, was little more than a sticking plaster, as most sensible pundits said at the time.

Greece ultimately depends on the generosity of German taxpayers

We've run through Greece's problems before, but the basic issue is quite straightforward. Greece owes too much money. The original bail-out package of €110bn was meant to be a loan to tide it over until it had sorted itself out.

That's not happening. The economy is shrinking, Greece isn't getting much better at raising taxes, and the interest charges on its existing debt pile could be ruinous.

Greece's national debt is set to hit 157.7% of GDP this year. As John Mauldin notes in his Thoughts from the Frontline newsletter, "no country save Britain at the height of its empire has ever recovered from a debt-to-GDP ratio of over 150% without a default". That would be a grim prognosis, even if Greece had a fantastic track record on these things. But it doesn't. The country has been in default for 150 of the past 200 years.

Overall it means that Greece will need properly bailing out ie, some of the money that has been loaned to it won't be paid back. The question comes down to "who pays for it?" That's where things get delicate. Ultimately, the easiest answer is to lump the majority of the bill onto German taxpayers. But getting to that stage won't be simple.

That's why the last thing Europe needs right now is the added uncertainty over the governance of the IMF. The arrest of the IMF head isn't a killer blow. These institutions don't all depend on one person. But Strauss-Kahn is a former French finance minister, who was planning to stand for election in France next year. So he had a keen interest in eurozone stability.

Eswar Prasad of the Brookings Institution in Washington tells Bloomberg: "the presumption was that with Strauss-Kahn at the helm, the IMF would not turn its back on Europe with Strauss-Kahn gone, that proposition becomes a little dubious".

As if that wasn't enough, Germans seem to be losing their fondness for the euro, notes Bloomberg. A survey reported in Bild am Sonntag said that 48% of Germans still support further aid to Greece, while 41% are against. But faith in the euro is falling 58% said their trust in the currency was "very low" or "quite low" compared to 54% in December.

The US has problems too

So what does all this mean for investors? Well, you'd expect the euro to fall further. And it might. However, there's a bit of a tug-of-war going on, as Kathleen Brooks of Forex.com puts it.

The US is set to hit its $14.3 trillion debt ceiling today. That's the amount it can legally borrow. Now, using 'extraordinary measures', Treasury Secretary Tim Geithner has managed to bump the absolute cut-off date back to August, which buys America's politicians some time to agree a deal on their budget.

However, it's not going to be easy. Both parties accept the need to cut the country's borrowing. But they don't agree on how to do it. Very broadly speaking, the Republicans want to cut benefits but not raise taxes. Whereas Democrats would rather sort out the deficit by raising taxes and not cutting benefits.

So we can expect a fair bit of Punch and Judy politics before an agreement is reached.

So which currency will come out strongest?

In this particular case, Europe's problems run deeper than America's. US politicians will almost certainly reach a deal. And if the country hits debt problems it can print its own money. That's not healthy, but it means it can never default.

Europe's woes are more entrenched. The key difference is that the US has both monetary and political union. Europe for now just has monetary union. So I suspect that Europe's problems will end up being the more serious.

But there's plenty of scope for wobbles on both sides until the debt ceiling issue and the Greek package are agreed upon. That opens up scope for trading opportunities in the euro and the dollar you should sign up for our free MoneyWeek Trader email to learn more about this side of things.

If, on the other hand, you're not keen to dabble in spread betting, the most obvious investment for now is to look at the current drop-off in gold as a buying opportunity. With both of the world's most important currencies under siege, gold is great portfolio insurance. You can see where our precious metals writer, Dominic Frisby, reckons gold could fall back to here: How far will silver and gold fall?

Our recommended article for today

Five ways to profit from euro turmoil

While the outlook for the eurozone is worrying, Europe remains full of good firms with strong balance sheets that are well worth buying, says Julian Pendock. Here, he tips five such companies.

John Stepek

John is the executive editor of MoneyWeek and writes our daily investment email, Money Morning. John graduated from Strathclyde University with a degree in psychology in 1996 and has always been fascinated by the gap between the way the market works in theory and the way it works in practice, and by how our deep-rooted instincts work against our best interests as investors.

He started out in journalism by writing articles about the specific business challenges facing family firms. In 2003, he took a job on the finance desk of Teletext, where he spent two years covering the markets and breaking financial news. John joined MoneyWeek in 2005.

His work has been published in Families in Business, Shares magazine, Spear's Magazine, The Sunday Times, and The Spectator among others. He has also appeared as an expert commentator on BBC Radio 4's Today programme, BBC Radio Scotland, Newsnight, Daily Politics and Bloomberg. His first book, on contrarian investing, The Sceptical Investor, was released in March 2019. You can follow John on Twitter at @john_stepek.