Daily State Of The Markets: Has The European Debt Crisis Returned?

Includes: DIA, IWM, QQQ, SPY
by: David Moenning

Anyone coming into Thursday morning looking for a sleepy summer session was in for a rude awakening as S&P futures were down hard three hours before the opening bell. For example, as my 6 screens flickered on at 5:15 am Thursday, I began perusing my news feeds. Then I saw the futures and did a double take. Wait. -15? What?

So much for the Wednesday rebound. So much for waving goodbye to phase II of the mo-mo meltdown. So much for the afterglow from Alcoa's earnings. So much for that better-than expected jobs report. And so much for the hoped-for rally resumption. No, it was obvious that something was up.

Recall that this has been a market that has experienced very little volatility since mid-April. This has been a market that has defied any and all forays by the bear camp for something on the order of 85 weeks (the last time the S&P 500 traded 5% below its 52-week high). This has been a market that has acted like a one-way street which, while it's been a little bumpy in 2014, had rewarded investors.

So why on earth would the futures be down 15, no, wait, make that 17 points? After all, a "big" pre-market move has been more like 4-5 points over the past few months.

What Was The Problem?

There it was. The headline in the FT: "Fears over Banco Espirito Santo trigger sell-off." It turns out that one of Portugal's biggest banks had missed an interest payment and was in trouble. Of course, with the bank's stock trading at somewhere around $0.60, one could argue that the idea of this particular stock being in trouble wasn't newsworthy.

Why would an obviously troubled bank, whose stock hasn't traded over $3 for more than 6 years, cause European bourses to be down 1 to 3 percent and traders in the U.S. to be running for cover? Haven't we been through this plenty of times since 2010?

Rate Contagion, Of Course

The answer is simple. Traders have seen this movie before and forgive me for mixing metaphors, but they know how to play the game. If "rate contagion" in Europe is back on the table, then you need to move to the "risk off" position. Sell stocks. Buy U.S. bonds, Buy gold. Rinse and repeat.

By now though, everybody knows that Super Mario (ECB President Mario Draghi) has a "bazooka" with which to fight the debt crisis in Europe and he has promised to use it if need be. And in short, the threat of the ECB starting to embark on an open ended QE program put an end to the European debt crisis and all the worries about rate contagion.

But The Bazooka Could Be Part of the Problem

However, that very same "bazooka" could be part of the problem right now. In fact, it may have actually created the problem. Assuming, of course, that there actually is a problem, which remains to be seen.

You see, when Super Mario started talking about doing whatever it might take to defend the Euro, aggressive investors sat up and took notice. Draghi's words meant that the risk of bond default in the eurozone had diminished. The ECB was there to backstop any problems (okay, I will admit that to be an exaggeration, but you get the idea).

This meant that hedge fund managers specializing in troubled debt could now start buying bonds in the PIGI'S (in case you've forgotten: Portugal, Ireland, Italy, Greece and Spain) again. Don't forget, in February 2012 long-term interest rates in Greece were over 29% (29.24% to be exact). Sure, there was risk that Greece might eventually implode. But come on, at 29% the risk was worth it given that Draghi was on the case, right?

Looking for "Love" in All the Wrong Places

As the fear of Europe's debt crisis eased throughout 2012 and into 2013, interest rates in Europe started going down in earnest. Investors hungry for yield started dipping their toes back in the water. And before you could remember who was in charge of the EU Commission or when the next important Supreme Court decision in Germany was, money was flooding into European bonds.

That 29% yield in Greece had turned into 6.9% as of March 31, 2014. The 6.6% yield in Spain's long-term bonds in 2012 was now 3.31%. And the 7.06% yield seen in Italy's bonds in November 2011 had fallen to 3.40%. Wow.

To put things in perspective, two and a half years ago, the fear was that these countries were going to default on their debt and that the eurozone was going to collapse. Now two of the PIGIS had yields near those of the United States!

In short, money has been flooding into European bonds in search for yield. And given the relationship of the PIGI's yields to the safe havens of the world, well, one could argue that the move might have become overdone.

What Happens If the Trade Reverses?

Apparently, the U.S. stock market isn't too terribly worried as Thursday's early losses wound up being largely reversed by the time the closing bell rang.

However, if you want to be worried about something, think about what would happen if some fear returned to European bonds? What if a couple more banks started going belly up in Portugal, or Spain, or Italy, or...? Don't you think that all of that fast-money might start flooding OUT of those European bonds? And then, where does it stop?

The bottom line here is that if rates start to backup in Europe due to concerns about the banking system, the money flows and the margin calls could easily produce the type of "meaningful" decline in the stock market that so many analysts have been calling for (and calling for... and calling for).

Granted, stocks didn't seem to care all that much on Thursday. But this is something that I for one am going to continue to keep an eye on.

Turning to This Morning...

Banco Espirito Santo's (OTC:ESFHF) troubles are being viewed by the bull camp as an isolated incident this morning. Goldman Sachs may have helped ease worries about the potential for rate contagion on the continent by writing, "Notwithstanding any further bad news, we think the sovereign financial implications are rather limited." In response, European bourses have recovered a bit. Here at home, traders are waiting on earnings from Wells Fargo (NYSE:WFC), which could set the tone on this summer Friday.

Pre-Game Indicators

Here are the Pre-Market indicators we review each morning before the opening bell...

Major Foreign Markets:

- Japan: -0.34%

- Hong Kong: -0.03%

- Shanghai: +0.42%

- London: +0.17%

- Germany: +0.03%

- France: +0.39%

- Italy: +1.11%

- Spain: +0.92%

Crude Oil Futures: -$0.43 to $102.50

Gold: -$1.00 at $1338.20

Dollar: lower against the yen, higher vs. euro and pound.

10-Year Bond Yield: Currently trading at 2.533%

Stock Futures Ahead of Open in U.S. (relative to fair value):

- S&P 500: +3.47

- Dow Jones Industrial Average: +33

- NASDAQ Composite: +12.71

Thought For The Day... Discipline is the bridge between goals and accomplishment. - Jim Rohn

Positions in stocks mentioned: none