Bullish Resilience Vs. Extremely Bearish News
On the one hand, the news this week was extremely bad for 2 of the top 4 economies,
- The EU: Greece is still at near term default risk, but much worse, the illusion that private holders of PIIGS bonds would somehow be spared losses officially died this week. That means both EU sovereign and bank debt is obviously far riskier. Not surprisingly, both sovereign and bank bond yields for anything connected with PIIGS debt have been spiking, including those of another too big to bail nation, Italy.
- The US: Hit with yet another disastrous monthly jobs report for the second straight month, that undermines whatever modest recovery hopes remain.
The week was also bad for the other 2 of the top 4
- China: more tightening AND its banks’ credit downgraded on after another half trillion dollars of hidden municipal debt is revealed after being missed by a national audit.
- Japan’s latest news was relatively less dire, just the continuing worsening of its radiation contamination and coming shutdown of additional nuclear plants, with associated power shortages that could affect factory output
On the other, major stock indexes held steady overall with either minor gains or losses despite the dire implications of the prior week’s events.
So, do we have a ridiculously resilient market, hanging tough despite blow after blow, just waiting for the next streak of good news, QE 3 or other excuse to fly higher, or one that’s about to collapse?
The potential for this exists in the coming week as we see in Part 2.
First a quick recap of the week.
Risk assets began the week moving higher, continuing from the prior week in Asia, with Europe indexes higher along with most other risk assets from continued belief that Greek crisis was now resolved for the near future. The optimism was based on 2 primary factors:
- Greece’s passing austerity measures demanded by the Troika in order to get the next bailout funds, followed by EU Finance Ministers agreeing over the weekend to release € 12 bln in new loans to Greece.
- A French plan for banks to “voluntarily agree” to accept 30 year bonds from Greece instead of cash for bonds maturing over the next 3 years, thus giving freeing up billions in cash otherwise needed for payments.
Both Asia and European indexes shrugged off poor Australia retail sales.
However markets backed off their Asian highs due to:
- An ominous sign (that would within days revive Greek default fears), a warning from S&P that the French plan was a selective default for the obvious reason that bondholders were taking losses, getting very risky long term Greek bonds instead of the cash payments due, without getting anything in return The point was obvious and true but the powers of denial are strong among the EU leadership.
- Comments from Eurogroup head JC Juncker that Greek sovereignty would be massively limited as a result of the new aid package, which brought angry remarks (but no effective denials) from Greek labour leaders.
It’s ironic that Mr. Juncker is frequently accused of dishonesty due to his excessively honest public admission that (shock!) EU officials, himself included, at times lie to the public during a recent Der Spiegel interview. This was newsworthy only because it was an admission of what was long obvious to anyone following the EU debt crisis, during which there was never any danger of default, until suddenly, there was, quickly followed by a bailout that had been in the works for some time. Once again Mr. Juncker was just stating the obvious. No one trusts Greek officials to manage funds responsibly, and thus EU officials will be carefully monitoring Greek spending.
- Not surprisingly, after 6 sessions of gains on the assumption that Greece was past its latest debt crisis, the EURUSD closed Monday topped out for the second time in a month at ~ 1.4560, just below its descending trend line dating back to July 2008 to its last lower high in May ~ 1.4800. This would prove to be the start of a weeklong plunge as the French “voluntary” bond rollover plan fell apart, leaving the EURUSD to close out the week at ~1.4263.
US markets were closed.
THE KEY POINT OF THE DAY, ARGUABLY THE WEEK: DEATH OF THE TRIOKA (EU/ECB/IMF) PUT FOR THE PIIGS
For those not familiar with options, a put option is a right to sell an asset at a given price called the strike price. Put options are often purchases as insurance against price collapses, because the buyer has the right to sell the asset at fixed price. Thus the option becomes more valuable as the asset in question drops below the strike price. For example if I buy a put option on ABC company with a strike price of $10/share, if the price falls to $8 my put option is now worth about $2 for each share covered, depending on how many options I bought.
Thus the “EU put” on PIIGS debt referred to the assumed refusal of the EU to let private PIIGS bond holders suffer a loss from a PIIGS bond default, in order to preserve the image of the EU as a united fiscal entity in which each state stands ready to serve as its brother’s keeper.
See below for details.
- Asia indexes were mixed/flat due to Moody’s threatened China bank credit rating downgrade as ~ $540 of new municipal bond debt was revealed beyond the $1.6 trln per by a national audit.
- European indexes closed mostly lower due toThe above China news, bad services EU data Moody’s downgrading Portuguese bonds multiple notches to Junk: saying that the nation’s attempt at both austerity and growth was unlikely to succeed (also, as with Italy, it’s exposure to other PIIGS nations bonds did not help) Death of French Bank Plan For Voluntary Bond Rollovers: Fitch and Moody’s joined Standard and Poors in refusing to consider the above noted French plan for voluntary Greek bond rollover anything but a default. That meant all 3 ratings agencies would label the plan a default. While the International Swaps & Derivatives Association, the final arbiter of what constitutes a credit event, had appeared willing to call the plan kosher, the opposition of the 3 big credit ratings agencies’ opposition clearly undermined the plan’s credibility as any hint of default could spark a market panic. Moreover, plan was further undermined by the news that French and German banks had already found a bigger sucker and dumped much of their Greek bonds and so any rollover would bring far less cash to Greece than previously thought. Thus unfortunately for the euro and the financial market, Greece is still at risk of default. The ECB and EU have other ways to help Greece if a default were to occur, however the psychological impact of even a selective default could panic the financial markets.
- The above China news, bad services EU data
- Moody’s downgrading Portuguese bonds multiple notches to Junk: saying that the nation’s attempt at both austerity and growth was unlikely to succeed (also, as with Italy, it’s exposure to other PIIGS nations bonds did not help)
- Death of French Bank Plan For Voluntary Bond Rollovers: Fitch and Moody’s joined Standard and Poors in refusing to consider the above noted French plan for voluntary Greek bond rollover anything but a default. That meant all 3 ratings agencies would label the plan a default. While the International Swaps & Derivatives Association, the final arbiter of what constitutes a credit event, had appeared willing to call the plan kosher, the opposition of the 3 big credit ratings agencies’ opposition clearly undermined the plan’s credibility as any hint of default could spark a market panic. Moreover, plan was further undermined by the news that French and German banks had already found a bigger sucker and dumped much of their Greek bonds and so any rollover would bring far less cash to Greece than previously thought. Thus unfortunately for the euro and the financial market, Greece is still at risk of default. The ECB and EU have other ways to help Greece if a default were to occur, however the psychological impact of even a selective default could panic the financial markets.
- Germany’s constitutional court continued to hear a lawsuit that could end up imposing tougher conditions for German participation in bailouts.
SEISMIC SHIFT: THE DAY THE EU PUT DIED
The really big news here, and for the entire week: All 3 major bond ratings agencies reject the French plan for banks to accept losses on Greek bonds and call acceptance of this arrangement voluntary, thus avoiding an official default. For-profit entities by definition do not forgo sums owed voluntarily, but rather only when left with no choice but to cut losses. There is no such thing as a voluntary acceptance of less than full value of a debt owed by banks or any for profit institution. Again, such things happen only when they feel forced to accept partial loss in order to avoid total loss.
With all 3 major ratings agencies refusing to call this proposed arrangement anything but what it was, a kind of default, the last hope for maintaining this pretense was over, and unless something is done to restore confidence fast, another Lehman-style contagion is just a matter of time, probably not much time, either. Here’s the basic idea.
Once one PIIGS nation defaults or even looks like it might do so soon, markets quickly shun all PIIGS bonds as well as those of any financial institution even possibly exposed to losses from them.
That’s called a contagion, a rapidly spreading banking and thus financial market crises as the solvency of a wider and wider group of governments and banks comes into question.
As in the spring of 2010(the last contagion), interbank lending stops, general credit availability slows, markets get scared and selloff hard until either some new rescue plan calms markets (like the €730 bln package of last spring) or assets fall far enough to price in a worst case scenario. With most indexes nearly double their March 2009 lows, that’s conceivably a 50% plunge if things really get out of hand. Just for illustration, look at how the bellwether S&P 500 shown below has risen since March 2009 from~ 730 to ~1340.
S&P 500 MONTHLY CHART COURTESY ANYOPTION.COM 01jul100332
You Really DO Own GREEK Bonds (Good Luck With That)
The official introduction of the French plan signaled that the Troika (EU/IMF/ECB) has abandoned attempts to create the illusion that they would always use taxpayer funds to protect private bondholders from taking losses on EU sovereign debt, for the sake of the greater good, the protection of confidence in EU and global banking, and thus its stability.
Yikes! That means those holding PIIGS bonds were actually betting on (gasp!) the dubious creditworthiness of that nation and not the far more creditworthy EZ core nations! If Greek bondholders are going to get stuck with dubious 30 year Greek bonds, holders of Portuguese, Irish, Spanish, etc bonds can expect similar treatment. So can many exposed to those holding those bonds, or to those who insured them. See how quickly the web of uncertainty spreads? The EU and US banking systems, each about equally exposed to PIIGS defaults, are now suspect.
This is a seismic change in perceived risk of PIIGS bonds and those exposed to them directly via ownership or indirectly via third party exposure to these bondholders as lender or insurer against PIIGS bonds default.
Given the above, it’s no surprise that signs of contagion have begun to appear:
- Sovereign peripheral EU debt yields started spiking to record levels. No surprise, given that both PIIGS and core EZ nations and their banks hold tens of billions of Greek bonds, and hundreds of billions in other PIIGS bonds.
- Moody’s dropped Portugal’s bond ratings to junk, essentially putting it on EU life support. That means Portuguese bond holders better get ready for losses similar to those that are coming for Greek bondholders.
- Italian banks have already been put on notice for credit downgrades due to their PIIGS bond exposure.
Expect to see the same for Spain, which has heavy exposure to Portugal. Then the fun really starts, because all the major players in the EU have exposure to Spain. If Spain can no longer afford to access credit markets, then it’s hard to see how risk of Spanish default and full blown contagion and market crisis can be avoided.
We’re surprised the EU tried to hit up private investors this early, given the contagion risk. We assumed they’d push off haircuts to private bondholders for a while longer while they prepared bank bailout plans to halt contagion risk. We still believe that’s what they’ll do in the near term, for any PIIGS nation at default risk.
MARKETS DIGESTED THE DEATH OF THE ECB/EU/IMF PUT
The market moving news Wednesday came Tuesday, with Asian and European markets falling hard as they digested the ramifications of Tuesday’s news as discussed above.
Adding to the air of desperation, some Eurozone financial leaders railed against the ratings agencies for daring to call the French plan the default that it obviously was, and the need to break their oligopoly. As if any credible replacement would do otherwise.
Asian indexes were mixed, European and US indexes were up on:
- Much better than expected US ADP monthly job claims
- ECB President Trichet’s saying that the ECB would still accept junk Portuguese bonds as collateral in order to prevent Portugal from rolling over before Greece is stabilised. Given that the ECB would already be rendered insolvent after having swallowed so much dubious Greek debt, what’s a few more suspicious Portuguese bonds?
- Oh yes, the ECB raised interest rates and hinted at more to come. Normally that would have the EUR flying higher, but in fact it continued to fall, indicating the depth of contagion concerns.
- Growing belief that the US debt ceiling would be raised and US default avoided.
Asian indexes were higher in typical delayed reaction to the good news from Thursday noted above, which came out after Asian markets were closed. However European and US shares fell hard, with US indexes wiping out most of the week’s gains. Here’s why.
- News about a much higher percentage of banks likely to fail EU stress tests due out next week
- More rumours about trouble in the Italian banking sector and possible resignation of Italy’s finance minister hit European shares hard. Spain is already considered too big to bail out, and Italy’s economy is even larger.
- US non-farms payroll was much weaker than expected. While one could argue that events in Europe this past week were more ominous, it was this report that objectively moved markets the most. US indexes lost most of their gains for the week, the EURUSD tanked yet again, gold soared as both major currencies look like bad places to keep ones assets. This was a huge disappointment given that:Thursday’s ADP non-farms payrolls were much better than expected. It was a big miss, only 18k jobs created vs. the 97-110k expected It was the second big miss in a row, and even worse than last month’s 25k jobs created.
- Thursday’s ADP non-farms payrolls were much better than expected.
- It was a big miss, only 18k jobs created vs. the 97-110k expected
- It was the second big miss in a row, and even worse than last month’s 25k jobs created.
Lessons & Ramifications From The Prior Week
CURRENCY HEDGES LOOKING BETTER
The underlying economies of both the EUR and USD have deep and worsening problems, suggesting that currency hedges like gold and silver will remain in their long term up trends. By the way, gold got down near the lower end of its Double Bollinger Band Buy Zone on it monthly chart, which has and continued to be a great support level for buying. See 4 RULES FOR USING THE MOST USEFUL TECHNICAL INDICATOR, DOUBLE BOLLINGER BANDS for rules about using double Bollinger bands. Indeed, gold completed its first 5 day advance this past week since April. Anticipated rising rates and the end of QE 2 have been cited as reasons for future gold weakness, but these must be weighed against ongoing weakness in the major economies which suggests rates remaining low, and possible additional stimulus that risks eroding currency value for the major currencies like the USD, EUR, JPY,GBP, and Yuan.
YET STOCKS, OTHER RISK ASSETS HOLD UP WELL
Yes, they sold off hard Friday, but overall lost little or still closed the week with a gain, as was the case with US indexes
With the top 4 economies all struggling and few doing any better our overall bias remains bearish, though as noted recently, shorting is to be avoided until you get a decisive signal of a new downtrend. That major indexes like the S&P 500 could actually gain this week despite the above news suggests resilience that, whatever the reason, we won’t attempt to fight until it’s exhausted. What’s keeping stocks higher? Possible reasons include:
- QE 2 Finished But Not Dead: While the $600 bln of bond purchasing from QE 2 is over the Fed, in addition to its “normal” permanent open market operations (POMO), continues to buy new treasury securities as old ones mature. With a $2.86 trillion balance sheet, that means it will continue to buy up to $300 billion of US government debt over the next 12 months from primary US bond dealer banks, which then typically use the cash to buy stocks just as during QE2. Thus potentially we’ve still another ‘half QE 2″ at work keeping bond prices up, rates down, and stocks up
- The Anticipation of Coming Q2 Earnings Season “Surprise” Rallies : If the recent past is any guide, markets are right to expect that no matter how earnings reports come out, most will be positive “surprises.” These should surprise no one, given that estimates are set low to allow for such surprises. Everyone involved in the process has an interest in such an outcome. Heck, even during the depths of the GFC, terrible results were often portrayed in the media as hopeful signs because they weren’t as bad as expected.
The key take away point: Even with all the dire news cited above, and real contagion risk getting closer, we suggest waiting and watching until market trends clarify. As we’ll note in Part 2, there are events that could keep markets steady or even moving higher if there’s no further deterioration yet in the EU.
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?