Plus One Way Out, Two Ideas For Investors
Part 1: Prior Week Market Movers & Their Lessons For the Coming Week
The following is a weekly strategy guide for traders and investors, covering prior week’s market movers and their lessons for the coming week for traders of all major asset classes via both traditional instruments and binary options. Perfect for those seeking a summary of prior week market movers & their lessons for the coming week and beyond, & a look at likely coming week market movers.
The EU crisis truly began in late 2009, just as market liquidity was draining out ahead of the US Thanksgiving holidays. News hit that some Dubai debt would default. Markets plunged, but soon recovered. However this got media focused on where the other potential sovereign defaults lay. Suddenly, the isolated warnings of the few about EU sovereign debt came into focus.
Here’s a quick recap of what happened and where we are two years later, and the 7 deadly sins that have, well, damned us to where we are now.
The crisis has grown worse on essentially 7 deadly sins, a series of denials, half measures too little too late that eroded market confidence. Instead of a quick, decisive commitment (similar to that of the US in 2008) to backstop any sovereign default and scare off speculators, we got:
1-5: Denials, Admissions & Aid Plans Too Little Too Late, Too Temporary
In sum, the first 5 sins
- Denials that there was a problem
- Admission of a problem, but assertions that there would never be bailouts due to the moral hazard involved, and that none were needed or requested.
- Admissions that bailouts were needed, quickly followed by requests for aid.
- Rescue packages too small, too late, fail to inspire confidence, contagion spreads beyond what bailout fund EFSF can handle.
- Short term solutions that calm markets for a number of months, allow for a tradable rally while underlying decay worsens.
6: The Deadliest Haircuts Since Sweeney Todd Backfire, Fan Flames of Contagion
The 6th step, when crisis began spreading beyond the small nations that the EU could afford to rescue, came this past July, as Greece came back for its second bailout. German officials pushed for and got partial default (aka 21% “voluntary” haircuts on Greek bonds) overriding ECB objections, including those of President Trichet.
The logic behind the haircuts was that:
- There was too much political resistance to provide cash available from the public sector to end speculative attacks on GIIPS bonds given that now that Portugal and Ireland were already also on the bailout dole, Spain was looking vulnerable, and there were numerous subtle signs of potential trouble from other nations.
- They made the sacrifices imposed on EU taxpayers from the latest rescue plan more palatable because now the banks would be sharing losses.
The critical fault in that logic, as we warned at the time was that imposing losses was virtually guaranteed to cause they very thing they were seeking to prevent, a spike in all GIIPS borrowing costs and spread of the financial crisis to countries previously untouched (and too big to rescue), like Spain, Italy and #2 core funding nation, France. Until then, EU sovereign debt still came with an implied assumption that it was still virtually risk free as private buyers would not take losses.
Low risk means low yields. Haircuts now meant this assumption of low risk was wrong, so yields had to rise to compensate for that risk. In a matter of weeks not only Spain, but also too big to bail Italy, were facing unsustainably high borrowing costs.
In a matter of weeks, the predictable effects of higher risk on sovereign debt, higher borrowing costs, began and continue until today, as summarized below, further fanning the flames of contagion.
Prior Week Market Movers: All About EU Deterioration
Once again, fear of a global crisis driven by the Euro-zone’s ongoing deterioration, or any news that eases it, is all that moved markets last week, that’s it. The EU’s worsening outlook is intensifying the negative feedback loop where weak growth aggravates debt burdens, which raises credit costs, adding further to debt burdens, and on and on.
A look at the daily charts of most risk assets last week show a steady decline, with the bellwether S&P 500 down nearly 4% on the week.
Yields on the debt of virtually all EU sovereign nations and the banks that hold those bonds rose, stocks in the more exposed banks continue their descent began this past summer. Italian and Spanish 10 year benchmark sovereign yields are dangerously close to the 7% redline that signals a need for assistance within a matter of weeks. However the cash isn’t there, nor at this time is there any agreed upon creative solution that circumvents this problem.
The 7th, Fatal Sin? CDS Market Murdered, Raises Risk, Yields On EU Sovereign Debt
Compounding the fear that fuels the contagion, another assumption that had previously supported demand for GIIPS has also fallen in recent weeks. Until the October EU summits, it was believed that you could always hedge your long positions on dubious sovereign bonds with credit default swaps (CDS), insurance policies against sovereign defaults.
However after the October debt summits upped the “voluntary haircuts” to 50% without these being ruled a default that would trigger a CDS payment, it appears that sovereign debt cannot be hedged, making it even more risky and thus inviting higher yields in the future. See here for further details.
Now borrowing costs for France, and even Germany, are also rising, as markets anticipate that eventually Germany writes some more big checks to avoid a global crisis. See here for details
Of course, there were many more lessons from last week, but others have covered them at least as well as I would, so why shlep this article out with more repetition. See here for John Mauldin’s take, the best I saw on last week’s development in a more detailed perspective focused on just last week.
Now What? Only One Way Out?
The only widely agreed upon creative solution (though still effectively opposed by Germany) is that the ECB announce it will print money and buy as many sovereign bonds as needed to keep EU sovereign borrowing costs affordable, legal and other consequences be damned. See here for details. Indeed the belief that this ultimately happens may be the only thing preventing a deeper panic driven plunge.
Lessons And Ramifications
Thus the flight out of risk assets continues, punctuated by brief rallies that are fuelled by a combination of sheer hope and technical bounces off support by short term bargain hunters.
Reflecting on the above, I can’t help but be stunned by the self destructive nature of at least 3 key policy decisions, each of which raised risk on EU sovereign debt and thus couldn’t help but to raise borrowing costs as credit markets demand compensation for the added risk EU inflicted on them. They are:
- Haircuts: Suddenly sovereign debt wasn’t backed by the EU and far from nearly risk free
- CDS Nonpayment: Even after forcing 21%, now 50% losses on bondholders we are expected to accept the polite fiction that these were not defaults and no CDS payments are due? Therefore EU sovereign debt can’t be hedged, and so is more risky and should pay a higher yield. How High? If you’re liable to take a 50% loss, so double the yield just to get back to your initial planned return – assuming you trust the EU for that. Given that the EU is getting less trustworthy, perhaps hold out for more.
- Capital Controls Too? As discussed in Part 2, Bruce Krasting reports that the EU is trying to force the Swiss to send all Greek deposits back to the Greek banks from which they came, in order to stem capital flight from Greece. These banks are unstable and depositors risk losing everything if this forced repatriation comes to pass. Worse, it sets a precedent for the EU to essentially steal its citizen’s money to prop up shaky banks that, if they fail, will take this money to their grave. More uncertainty, more risk.
SHORT TERM: MAY SEE TEMPORARY RISK ASSET RALLIES
If the past two years are a guide, markets could bounce on a combination of bargain hunting and hopes for short term relief from some form of money printing.
LONGER TERM: GOING DOWN
With no real solutions in sight to a crisis that could easily bring us back to March 2009 lows (for reference, S&P 500 ~700), and risk assets still only about 11% down from multi-year highs seen in May (S&P 500 still above 1200), the path of least resistance remains downward
WHERE TO RUN?
In the coming months:
- Risk assets are likely headed lower
- Most safe havens don’t look appealing:
- Sovereign bonds look vulnerable and yields are low Of the three traditional safe haven currencies, the JPY, CHF and USD, two (JPY, CHF) central banks that are in active intervention mode to keep them down, and the Fed is actively considering new stimulus that could hurt the USD.
- Sovereign bonds look vulnerable and yields are low
- Of the three traditional safe haven currencies, the JPY, CHF and USD, two (JPY, CHF) central banks that are in active intervention mode to keep them down, and the Fed is actively considering new stimulus that could hurt the USD.
So playing longer term long positions in safe haven currencies could be treacherous.
TWO IDEAS FOR INVESTORS
For Capital Gains: The consensus is that we’re heading for rougher times that will prompt more currency-devaluing central bank stimulus. That in turn suggests that gold, despite its recent travails, may yet soon retake $1800 and continue its March higher.
For Income: Defensive dividend stocks with safe, higher dividends, particularly those from countries with healthier balance sheets like Canada and Norway.
DISCLOSURE /DISCLAIMER: THE ABOVE IS FOR INFORMATIONAL PURPOSES ONLY, RESPONSIBILITY FOR ALL TRADING DECISIONS LIES SOLELY WITH THE READER. IF WE REALLY KNEW WHAT WOULD HAPPEN, WE WOULDN’T BE TELLING YOU FOR FREE, NOW WOULD WE?