Market to Force Hand of Central Banks

Includes: SBND, TBT
by: James A. Kostohryz

Remember that 1,180 to 1,220 support band on the S&P 500 (^SPX) that I have discussed in recent articles, here and here. Well, by mid-day on Friday, August 5th, the market was slicing through that like a knife through butter. At this rate, the market may be heading towards a date with the 950-1,020 area of support on the S&P 500 (^SPX) that was discussed in my recent article: “The Market’s Downside: S&P 950.” That is probably the last area of support before the market signals that it is discounting significant probability of a total collapse of the global economy.

The problem with such a decline is that it could literally guarantee the outcome of a collapse. Stock market declines of this magnitude could throw economies around the world into recession. Thus, we are confronted with the specter of aggressive and coordinated central bank intervention around the world to support the value of financial assets.

Investors should beware of the probabilities of major announcements of creative schemes to be implemented by central banks around the world in a coordinated manner. There are many alternatives. One obvious alternative is asset purchases. Another is rate decreases as many central banks around the world (weirdly including the ECB) still have nominal interest rates substantially above 0%. Another mechanism is coordinated bank liquidity facilities.

Perhaps the most intriguing option could be the creation of funds that would collateralize or guarantee interest payments on bondholders of long term debt. The funds would guarantee only interest payments and not principal, to get more bang for the buck. This could be funded initially with central bank guarantees, backed up by sale of assets by beneficiary countries. The assets would be sold in conjunction with central banks, say the ECB, and the funds would then serve as a collateral base for guarantee facilities.

I estimate that such funds would become credible for a country like Spain with a fund with equity equivalent to 7% or so of GDP. For a country like Greece, the figure might be something more like 12%. Italy, perhaps 10%. All of these countries have marketable public assets of this order of magnitude.

There are many creative arrangements that can be thought of. I expect central banks to actively consider them in the coming days.

The announcement of such plans could catch the markets by surprise and generate violent rallies. A small preview of what can happen can be illustrated by Friday's sudden intra-day reversal in which the S&P 500 went from a free-fall that took it to 1,168 to a value of roughly 1,213 -- a gain of 45 points, or almost 4%, in less than an hour. This was prompted by a relatively tame and toothless announcement by the ECB that it would support Italian and Spanish bonds if both countries committed to certain reforms.

Can you play those rallies? It would be very difficult. The market can decline another 10% to 15% before it shoots up 10%.

The only viable risk-controlled strategy I can see would be straddle spreads. In this strategy, the investor would sell the side of the straddle that makes the first large move. This would hopefully take the basis cost down to zero. Then he would hold the other side of the straddle waiting for a counter-reaction. The spread aspect of it, is to deal with the high implied volatilities in the market right now.

I think the other viable trade out there right now is shorting long-term Treasuries. It's essentially a win/win situation. If central banks are successful in preventing recession, long-term Treasury yields must rise. Real rates are unsustainably low. On the other hand, if central banks fail to prevent recession, then either default or inflation is the inevitable outcome. Either way, Treasury yields rise.

This latter plan can be executed either by shorting Treasuries directly or by going long ETFs such as SBND or TBT.

Disclosure: I am long SBND, TBT.