November started out much the same as October. Global markets plunged. By October 4th, however, most indices had bottomed and proceeded to embark on a historic month-long rally in anticipation of some kind of tangible action to quell the eurozone debt crisis. As of October 30th, Toronto’s TSX was up about 7.7% on the month while the S&P 500 was up a whopping 13.5%. Those gains moderated somewhat to 5.5% and just shy of 11% respectively because of the Halloween dip.
So what caused the October bounce and subsequent fall from grace? Perhaps there were just enough rumours of a eurozone debt solution throughout October to float some hope and squeeze some shorts. Perhaps it was the improved U.S. GDP stats and hopeful earnings reports by some large U.S. corporations. Perhaps it was the prospect of China coming to the rescue with their big bag of reserves. Perhaps it was all of the above and more.
What then, caused the rather sudden Halloween reversal? The European debt framework was announced very early Thursday morning and kicked off a “face-ripping” rally across the globe. That enthusiasm had already subsided by Friday and headed decidedly in the opposite direction on Monday and Tuesday.
Why the Rally Fizzled Fast
- Voluntary Haircuts: The European debt deal supposedly included voluntary debt reductions of 50% for institutional holders of Greek bonds. Many have begun to realize that this does not mean that public bondholders like governments will offer the same haircut. Some will stick with the original 21% offer and others won’t take any haircut at all. Details are sketchy, to say the least.
- Capital-Raising Reality Check: As part of the agreement, European banks would be expected to raise capital to shore up their balance sheets. With many of their share prices having already experienced haircuts of their own, this may be easier said than done. Confidence in European banks isn’t exactly flowing freely among potential investors.
- Defining Default: If you offered to pay the bank $100,000 of your $200,000 mortgage and call it a day, would they consider your loan to be in default? You bet. It’s still unclear whether the ISDA is going to call a 50% haircut on Greek debt a default. The semantic sticking point is the word “voluntary.” I guess if banks volunteer to take the hit it’s somehow not a default?
- Credit Default Swaps: It seems like every discussion of the debt crisis comes back to those pesky, opaque, unregulated CDS. The ISDA (International Swaps and Derivatives Association) treatment of the Greek haircut reminds us of the reality that the financial system is still being held hostage by these WMDs. If the ISDA deems Greece to be in default, the CDS on those bonds will be triggered, creating a chain reaction that no one seems to truly comprehend. If they decide that Greece is not in default, then we have to ask what CDS are really good for anyway.
- Where’s My Haircut? Suppose your neighbour got away with the $100,000 discount on her mortgage. Would you maybe like to get the same deal? That’s what many are hoping Spain, Italy, Portugal, Ireland and others won’t do. It’s clear that neither the troika, the taxpayers nor the financial system can support haircuts and bailouts for all.
- China to the Rescue: Much of the market euphoria had to do with hopes that China might come to the table with a lot of money to help stem the crisis. Some think China has enough problems of its own to deal with at the moment. China itself has said that they are willing to help, but that the real responsibility for cleaning up the mess rests in Europe. The fact that China reported weaker than expected PMI data didn’t help either.
- Greek Referendum: On Monday, rumours began circulating that Greece would hold a referendum on whether or not to accept the terms of the proposed bailout. Markets didn’t like this.
- MF’s Monumental Failure: MF Global, a large brokerage and primary dealer filed for bankruptcy protection on Monday, exacerbating market fears about European contagion. With reports circulating that MF Global failed to segregate client collateral and the small matter of a missing $700 million, this news did little to help investor confidence. Don’t worry about CEO Jon Corzine though. The former Goldman Sachs CEO and New Jersey governor will reportedly receive $12 million for his stellar performance over the 19 months he headed MF Global. (And we wonder what those Occupy kids are so upset about.)
It is often said that the bond market is a lot smarter than the stock market. Last week, when stock markets were giddy about the prospects for any kind of euro debt fix, credit markets were still expressing skepticism. Perhaps they are once again playing superego to the stock market’s id.
The secular bear market that began in 2000 has seen its share of extreme moves both to the upside and to the downside. There have been scary declines that suddenly turn to short-killing rallies. There have also been hope-induced rocket-rides that terminate in disappointing reversals. Heck, we’ve seen all of that just in the past month.
So if we’re in the middle of a quick move lower, what could lead to the next whipsaw higher? For one thing, rumours that Greece is backtracking on the much-hated referendum idea are hitting the wires as I write this and markets, though still negative, have rallied back a little on the news. For another, the Fed could whisper QE3 again – possibly soon.
More Fed action could clobber some newly-minted short positions and light a fire under the gold price. It would be a triumph of the financial id. Hmmm … I wonder what the superego will have to say?