Fixed Income Markets Predicting The Future Of The Eurozone

by: Ananthan Thangavel

The past week saw the third straight weekly gain for the S&P 500, as well as a continued rally of the euro. Markets continued to cheer each and every rumor emanating from Europe with yet more buying of risk assets. We continue to remain bearish, as none of the proposed solutions in Europe will come close to solving the real problem, which is overindebtedness and an overvalued currency.

The following charts show the CRB RIND as well as the GSCI Total Return Index. Click on all charts to enlarge:

-chart courtesy of 10/21 Commodity Analyst Newsletter -

-chart courtesy of 10/21 Commodity Analyst Newsletter -

As can be seen, the CRB RIND has not rallied with the market despite risk assets taking off in the past few weeks. In fact, Thursday saw the CRB RIND hit a new 1-year low, falling over a full percent on the day. By contrast, the GSCI Index has rallied quite a bit off the bottom in early October. It appears that recent buying has been speculative in nature, with raw commodity buyers staying mostly on the sidelines. With companies such as Alcoa (NYSE:AA) missing earnings estimates, commodity producers could take a beating in coming quarters as prices decline from lofty levels.


However, while commodity prices are certainly a concern, the true determining factor remains Europe. Despite the seemingly bullish headlines coming out of Europe, the situation is actually getting worse with each passing day even as stocks rally.

The following chart shows the difference in yield between German 10 year bonds and French 10 year bonds.

-chart courtesy of 10/21 Commodity Analyst Newsletter -

As can be seen, the spread between these 2 countries' debt is increasing at an alarming pace. If you have been following our recent analysis, this should not be all that surprising. French banks have much more PIIGS sovereign debt exposure and are more leveraged than German banks. To make matters worse, Germany wants France to recapitalize their own banks before using the EFSF funds. As we discussed previously, if France were to take on the liabilities of even one of their 3 largest banks, their debt rating would plummet as their effective debt load skyrocketed. The recent impasse in European negotiations is predicated on just this point.

Until the past couple days, France has been sticking to their request that the EFSF be able to borrow funds from the ECB. This is a fancy way of saying the ECB should print money and lend it to the EFSF. France is correct that this would stem the crisis. It would devalue the euro massively, but it would end the solvency risk of Europe in that the EFSF would be able to tap the money-printing machine of the ECB.

However, Germany and the ECB have made it repeatedly clear that this will not happen. Because of their strong cultural aversion towards inflation, Germany will not stand behind any money-printing or currency-devaluing action. Since Germany is considered the only strong country in Europe at this point, this means that money-printing is off the table for now. France backed down a couple days ago, saying that they will not demand that the EFSF be allowed to borrow from the ECB. This is not an indication that they have found another way to solve the crisis, it is simply the resignation of the French authorities that they have little control at this point.

Germany's preferred solution of using the EFSF as an insurance fund is, for lack of a better word, a joke. The EFSF is currently capitalized with 440 billion euros. After deducting for existing commitments to Greece, Portugal and Ireland, that number comes closer to 325 billion euros. The way the insurance option would work is that the EFSF would guarantee a certain portion of the losses on new sovereign bonds issued by certain countries. Theoretically, insuring new bond issues would solve the rolling over of debt problem. The PIIGS countries have to roll over about 1 trillion euros of debt by the end of 2012.

However, the rate of insurance is the real problem here. What is the level of insurance that the market would accept in order to assuage their concerns about buying European sovereign debt? Considering a 50% haircut has been proposed for Greece, and that a 21% haircut has already been agreed to, let's go with 40% as a figure (to give the Europeans the benefit of the doubt; in fact, recovery rates in sovereign defaults could be much, much lower than 60%). This would mean that the EFSF would have the effect of insuring about 812 billion euros of sovereign debt. Given a 1 trillion euro refinancing for the PIIGS over the next 15 months, this amount seems woefully inadequate. If Belgium or France starts to have problems as well, you're looking at an absolute catastrophe, as the 1 trillion figure is only enough to help the PIIGS.

As we have stated numerous times, the downgrade of France is most likely the next major negative catalyst in Europe. Both Moody's and S&P stated this week that France's credit rating could be at risk. This is an absolutely huge development that the markets glossed over. If France loses their AAA rating, Germany will be the only "strong" country left standing. Given how leveraged French banks are, a large decrease in French sovereign bonds' price could leave a large portion of the French banking system effectively insolvent. This would enact the nightmare, global financial meltdown scenario.

It is our opinion that France and Belgium will both lose their AAA rating at some point over the next 3-6 months, which may bring about the final frenzied leg of this crisis that forces the ECB to resort to the bazooka solution of printing euros to save Europe. After all, even though the market currently perceives Germany as strong, it really is not all that strong when you consider that even Germany itself does not control its own currency unilaterally. Germany's debt to GDP ratio has increased from 66% to 83% since the beginning of 2008, and it is not out of the question that the market may eventually question Germany's creditworthiness as the entirety of Europe slips into recession. Just a few weeks ago, France's debt was considered rock-solid, and that has started to unravel at an alarming pace. Once markets lose confidence, it is extremely difficult to consider them otherwise.

While risk markets have priced in a rosy outcome from this week's meetings, investors should be very wary. Fixed-income markets continue to tell a much different story, and this problem is one of solvency in the fixed-income market. Just as the subprime collapse preceded the stock market collapse by more than a year, equity and risk markets may remain irrational for quite some time, but a blowup in the fixed-income market will always lead to ruin. As is usually the case, your ability to profit from this situation depends solely on your ability to withstand the volatility associated with a bear market, and ignore day to day moves.

ECB Interest Rates

In addition to the announcements coming out of the G20 meeting, the ECB will announce interest rates on November 3rd. While Trichet kept rates high due to his desire to not tarnish his legacy (which he already has), we believe Draghi has no choice other than to cut interest rates. An interest rate cut would be a significant negative catalyst for the euro, as the carry trade being long the euro and short the dollar is undoubtedly supporting the euro-dollar exchange rate somewhat. Even if an interest rate cut is not announced at this meeting, it is an inevitability as austerity in the Eurozone drives the continent into recession.


Amazingly, it also seems that the market is now starting to price in QE3 yet again. On Friday, with risk asset markets up broadly and handsomely on the day, the yen somehow rallied more than 1% peak to trough against the dollar. The only explanation for this can be that the market is again expecting the Fed to act at its next policy meeting on November 2nd.

We cannot overstate the unlikelihood of this event. With three dissenters, a wildly hostile republican party, and the S&P less than 10% off the 52-week high, Bernanke has literally no justification for increasing the size of the Fed balance sheet. Operation Twist just began, and, in his eyes, it may just well be working given the increase in the S&P 500 as of late. We continue to believe there may eventually be a QE3 in the US, but it will not happen until the Fed is pushed to its last resort by renewed crisis. This means the S&P would have to be in the 900-1050 range. Unfortunately, monetary policy has become a political weapon, and Obama and the Fed cannot deploy it unless it is popular. The republicans have been able to convince the population that expansionary fiscal and monetary policy is somehow holding them back, so until the population starts to support fiscal and monetary stimulus, Bernanke will most likely sit on his hands.

Trade Recommendation

Both the ECB and FOMC meeting are large possible upcoming negative catalysts for the euro. While the announcement from the G20 meeting may cause a rise in the euro due to a perceived bullish outcome, we continue to believe the positive surprise has already been priced into the euro.

We recommend shorting the euro outright at a price of 1.3900 or better. Even if short covering causes the euro to rise significantly above it, we would strongly advise traders to take advantage of such attractive pricing while it lasts in order to establish this position for the long-term.

US Stocks

For all the aforementioned reasons, we remain bearish on US stocks. While a P/E ratio of 13.3x on the S&P 500 looks very cheap, considering that earnings have exploded since the March 2009 bottom, earnings could be just as volatile on the way down. With a negative national attitude towards debt and monetary stimulus for the first time in years, an essential part of final demand, government spending, is being pared back across the board. We continue to believe that earnings estimates are far too rosy over the next 1-2 years, and that the current valuation of the stock market is not nearly as cheap as it appears.

The following chart shows the S&P 500 index.

-chart courtesy of 10/21 Commodity Analyst Newsletter -

As can be seen, to get back to April's high, the stock market would have to rally about 10.5% from current levels. Going back to the lows of earlier this month, stocks would have to fall about 13.5%. Even if one was bullish about stocks at current levels, the current risk/reward characteristics of the stock market are not supportive of a long position. The macroeconomic risks could easily take stocks down to new lows, and indeed we expect the S&P 500 to trade below 1000 at some point over the next few months.

The following chart shows the Put Call ratio for equities.

-chart courtesy of 10/21 Commodity Analyst Newsletter -

The put call ratio is useful as a contrarian indicator, as when investors are purchasing puts at a very fast rate comparatively to calls, they are usually too bearish and the market is poised to rally. At our current levels, the put/call ratio stands around the average for the past few years, and just reached the lowest level since September 20th. Interestingly, September 20th marked an interim top, with the S&P falling 12% over the next 2 weeks.

The following chart shows the American Association of Individual Investors bullish sentiment readings divided by bearish sentiment readings.

-chart courtesy of 10/21 Commodity Analyst Newsletter -

As can be seen, there have been more bulls and bears for the past 2 weeks, a fairly neutral reading. The combination of the put/call ratio and the AAII survey lead us to believe that sentiment is neutral to bullish right now, leaving the potential for contrarian rallying highly diminished. Overall, it appears that investors have become fairly complacent over the past 2 weeks, and this type of complacency is usually indicative of a precipitous fall in the face of poor fundamentals.

Trade Recommendation

We recommend shorting S&P futures at a price of 1235.25 or better. A fairly tight stop loss of around 1250-1275 could be used if investors are worried about the S&P 500 breaking range and technical traders jumping on the bullish bandwagon, but we continue to have high conviction that US stocks are overvalued at current levels.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. Short euro futures, short S&P futures.

Disclaimer: All information included herein is the opinion of the firm and should not be considered investment advice. Past performance is not necessarily indicative of future results.

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