As we saw in Part 1, the very bearish fundamental picture finally hit market and is now starting to be reflected on the charts. Indeed, per the technical picture we saw, markets are teetering at the edge of an abyss that could lead to the lows of March 2009
Coming Week Top Market Movers
Market Reaction to S&P Downgrade of US Credit Rating From AAA to AA+
The downgrade of the US’s credit rating may rattle already nervous global asset markets. The big risk is that this actually sparks some serous USD selling as it winds up creating some kind of “credit event” (major institution suddenly insolvent). That’s not expected, for a variety of reasons. Primary among these is that, as we noted last week,
- There are few assets liquid enough for big players like China or other large sovereign wealth funds to park their money.
- Any major selloff obviously would devalue the remaining holdings of these large funds faster than they could sell them, so they won’t. They just won’t buy as many new ones.
- The move by S&P was not unexpected, given how little new deficit plan actually does to reduce the US’s massive deficit, the plan is a mere band-aid, not long term solution that credit agencies would have preferred. The US is still lacking the political will to make real headway on its deficit.
So while we do expect reduced USD demand over time, we don’t expect to see a major USD selloff. Moreover, if markets are even slightly afraid of the chance of the following potential market mover happening, the US credit downgrade, and virtually everything else, will be a secondary.
Further Developments in EU Sovereign Debt & Banking Crisis: Germany to Give Up on the EU?!
There is plenty of potential in the EU’s spreading contagion to continue dominating market movements. For example, the German paper Der Spiegel reported (via zerohedge.com) that German PM Merkel’s advisors are opposed to any German participation in a bailout for Italy. Key points these advisors make:
- Italy Too Big For EFSF To Save – Spiegel
- Doubts Whether Tripling EFSF Would Help It Save Italy
- Italy Must Make Savings, Reforms To Exit Crisis – Spiegel
- Italy Debt Guarantee Could Raise Doubts About Germany’s Finances – Spiegel
- EFSF Should Only Help Small, Mid-Size Countries – Spiegel
If Germany now opposes expanding the EFSF bailout fund to a size that could backstop Spain and Italy, then that means bondholders of these nations have nothing to rely on but the ….gulp! credit worthiness of Spain and Italy! That means more rising GIIPS-C (C for Cyprus, latest bailout bad boy) bond rates, which are already approaching 7% for 10 year bonds, a rate that has typically forced other nations to concede that they can no longer afford to access capital markets and need a….bailout. Unfortunately, both Italy and Spain have far too much debt for the current EFSF to cover, so if Germany, the biggest contributor, is bowing out, then the EZ and EUR as we know it kaput.
Anyone who thinks China will gladly step in and fund a $5 trillion EFSF shortfall should read the following article from Reuters, the key point of which is:
Italian Economy Minister Giulio Tremonti said on Thursday that Asian investors are reluctant to buy Italian bonds because it sees they are not being bought by the European Central Bank… they (Asian bond buyers) say ‘if your central bank doesn’t buy your bonds, why should we buy them”?
Indeed, if in fact Germany is giving up on trying to bailout Spain and Italy, understandable given the size of that undertaking, then THAT my friends will likely be THE market driver of the week, to put it mildly.
It would mean at minimum a global financial crisis far beyond that seen when Lehman Brothers fell, with the solvency of virtually every EU member and major bank now in question, and those same questions would spread fast to the rest of the global banking community, causing at minimum another interbank and credit freeze as seen in 2008 and in the spring of 2010.
Virtually every major EU banks, and many outside Europe, have significant Italian bond exposure. For example, French banks alone have about $511 billion of Italian bonds, an amount equal to roughly 20% of French GDP. France has similar exposure to Spain, which would likely be sucked down with Italy as it too would be shut off from credit markets. However, that would mean French banks lose an amount equal to about 40% of French GDP. Where would that leave France, and anyone exposed to all those French banks? See here for more on who gets hurt from an Italian default.
Meanwhile, there were reports on Friday that EU leaders are meeting this weekend to discuss measures to keep the EU together and stabilize the rising bond yields of Spain and Italy. Measures mentioned included that the ECB will be buying Spanish and Italian bonds (would be quite a feat considering that’s roughly 3.5 times larger than Portuguese, Irish and Greek markets combined). We find it difficult to believe there is that much political will for such a large increase in the bailout fund given what we’ve seen thus far, yet equally difficult to believe Italy will be allowed to default, even if the Euro must be printed on a scale that would shock Ben Bernanke himself.
FOMC Rate Statement, Press Conference
Despite the poor data, the Fed is not expected to announce any new stimulus at this time. We expect the Fed maintain their language of keeping rates low for an “extended period” and wait for more data, thus making Tuesday’s meeting a potential nonevent. However, we would also note the potential for markets to express disappointment if the Fed does not signal a return to QE, as we expect.
Top Earnings Announcements
With most major names having reported earnings announcements are unlikely to have much influence this week.
Top Calendar Events
It’s a typical second week of the month relatively lighter economic calendar. Key events include: (most important in bold)
- Tuesday August 9: AUD home loans CNY CPI y/y, fixed asset investment, industrial production, PPI, retail sales, GBP manufacturing production, CAD housing starts, USD FOMC Rate Statement
- Wednesday August 10: AUD Westpac Consumer Sentiment, CNY new loans, trade balance, EUR French ind. Prod. m/m GBP BoE Gov King speaks, BoE inflation report
- Thursday August 11: AUD employment change, employment rate, CAD trade balance, USD trade balance, first time jobless claims
- Friday August 12: EUR: French prelim. GDP, CPI, NFP, US retail sales, UoM Consumer sentiment
Disclosure: No positions.
Disclaimer: The above is for informational purposes only. All trade decisions are solely the responsibility of the reader.