Prior Week: 5 Credit Issues That Squelched A Rally

 |  Includes: DIA, QQQ, SPY
by: Cliff Wachtel

Part 1 of Weekly Review/Preview: Prior Week Market Movers & Their Lessons For the Coming Week

Considering the potential fuel for volatility, the week’s price action was remarkably dull. Volatility could have come from a number of sources, including:

  • This week being the first trading week of the year and the first with any real volume as traders return from vacations
  • Important data (including US monthly jobs reports), EU bond sales (that provide regular tests of EU crisis fear)
  • This being the week before the start of Q4 2011 earnings season

Yet after Tuesday, most risk asset prices showed little net change over the rest of the week.

In theory, the good world-wide manufacturing data and US jobs reports should have kicked off some kind of risk asset rally.

However, 5 EU credit concerns squelched what could have been a rally this past week.

Prior Week Market Movers

Tuesday: Good Data Boosts Risk Assets

With so many markets closed Monday in observance of New Year’s Day, Tuesday was the first real trading day, even though Japan and China remained closed. Stocks and other risk made their biggest gains of the week by rising ~ 1.6%. They were little changed for the rest of the week. For example, the bellwether S&P 500 was unable to overcome resistance at its multi-month closing high of 1285.

Manufacturing data from China, India, and Europe boosted buying early on. The US December ISM Manufacturing Index kept the positive vibes as it improved to 53.9 from 52.7 in November so that it exceeded the reading of 53.4 that had been widely expected.

Wednesday: New Signs Of EU Liquidity Woes End Rally

Virtually all risk asset rallies halted or reversed Tuesday, mostly due to a combination of 5 disturbing reports that together reminded markets about fears of EU sovereign and bank insolvencies.

  1. EU banks deposited a record €453.18B ($591B) in the ECB’s overnight deposit facility, up from €446.26B on Monday. Banks borrowed just over €15B from the overnight lending facility, a minor increase from Monday’s €14.825B. The message is that banks are not using the cheap loans from the ECB’s LTRO to buy GIIPS bonds (surprise!-not). This came after news on Tuesday that an unusually high €14.8B was drawn on the ECB’s marginal lending facility on Monday. These short term loans incur a penal rate of 1.75%. This suggests that whoever was using it was having year-end difficulties that have yet to be resolved.
  1. UniCredit (OTCPK:UNCFF) approved the terms of a new issuance of 3.86B new shares at a steep 43% discount to current prices as it seeks to raise €7.5B ($9.8B) in new capital, suggesting enormous difficulty drawing investors willing to take a chance the bank’s survival. Remember that Unicredit is one of the leading banks in Italy and Europe, and thus likely to survive or be bailed out in all but the worst case scenarios, which apparently markets deem as too likely for comfort.
  1. Madrid stocks lead European indices lower after the Spanish newspaper Expansion reports that the government is considering applying for rescue loans from the IMF and EU.

Adding to anxiety over the EU:

  1. A “successful” German bond auction that on closer examination looked good only relative to last month’s failed auction. While yields were lower, Germany had wanted to sell €5bln in bonds, received bids for only €5.14 bln, and accepted only €4.1 bln. The bottom line here is that even Germany is not getting the demand it would want for its bonds.
  1. Reports that Hungary is running low on cash as the Florint hits monthly lows against the falling EUR. This latest trouble follows Hungary’s new banking law that strips its central bank of independence in defiance of the EU and IMF, who provided Hungary with a $26 bln bailout in 2008. Hungarian sovereign borrowing costs also soared. Hungary’s troubles are significant because Austrian banks have huge exposure to Hungarian bonds. Austrian banks have ~ $226 billion in exposure to eastern Europe and total asset holdings there of €1.14 trillion ($1.6 trillion) at the end of June. The size of the entire Austrian economy was $332.9 billion in 2010.

Not surprisingly, most European indices closed the week lower, while US indices finished the week higher.

Thursday US Jobs Data Provides Some Lift

The big news Thursday was the overall encouraging US jobs reports that fueled speculation that the big official ones Friday would be good.

Friday’s Positive US Jobs Reports Moves Markets – In Opposite Direction

The headline numbers were great. In December, the US added 200k nonfarm payrolls, and the unemployment rate fell to 8.5% versus economists’ expectation of 155k and 8.7%, respectively.

In the recent past, when US monthly jobs reports beat expectations substantially, that put markets in “risk-on” mode, sending stocks and other risk assets higher and safe haven assets like the USD lower. This time the opposite occurred. Stocks sold off and the USD rose. Here’s our take on why:

  1. Stocks sold off because:

a) “Sell The News Setup”: Prior good US jobs data had raised expectations for a good report, so we had a classic “sell the news setup,” aided and abetted by the potential for bearish news next week both from the EU and US (see Part 2 on coming week market movers).

b) Weakness Behind Headline Numbers: These were believed to be too optimistic because:

  1. I. Much of the gains were from holiday hiring, particularly from delivery companies, and thus unlikely to represent permanent hiring. Moreover, these are relatively low wage jobs, while the US continues to lose higher wage jobs, as exemplified by the carnage in US banking staff cuts in the past months.
  1. II. Gains in official unemployment were also believed to be helped by declining workforce participation by those needing to work but having abandoned hope of doing so per official labor statistics.

c) With real growth weak, the best hope for stocks in recent years has been the temporary benefits of assorted stimulus programs. The good headline numbers made new QE less likely.

d) Technical Resistance: US indices were already at strong technical resistance. For example the S&P 500 was back around 1280, which has been an unyielding resistance level since late of October 2011, having been tested 6 out of the past 11 weeks (highlighted) without breaking.

ScreenHunter 01 Jan 07 23 542  Prior Week Market Movers: 5 Credit Issues That Squelched A Rally & More

S&P 500 WEEKLY CHART 3 JULY 2011 – 6 JANUARY 2012 01 jan 07 2354

  1. The USD strengthened because:

a) The data lowered the chances for additional QE (which hurts the USD) in the near term. If the improving jobs data turns out to be real, it would even suggest a slight increase in expectations for interest rate hikes. In other words, the USD may again be moving on improved fundamentals that improve the prospects of Fed rate hikes, rather than solely on demand for the USD as a safe haven currency in times of deep uncertainty.

b) The EUR’s ongoing weakness from Wednesday’s news and potentially EUR-bearish events next week (see Part 2) which by necessity boosts the USD.

Noteworthy But Not Market Moving

The following didn’t move prices but are worth noting for coming weeks.

Tuesday: Greece, FOMC Minutes

Greek EZ Exit Threat: Reports that Greece was threatening to leave the Euro-zone if it didn’t get its next round of bailout cash. Italy’s Linkiestra wrote that EU leaders will informally discuss a Greek exit at the next EU summit later. Markets shrugged off the news. That’s not so surprising given that

  • A Greek exit threat “at some point” is not new
  • The threat is not immediate and thus remains in the “at some point” category
  • Greece is clearly not eager to make good on the threat given the pain involved and it’s prior past threats that came to nothing.

The FOMC Minutes revealed nothing new and thus were also a non-event for price action.

Iran Saber Rattling In Response to US-Led Sanctions

US led economic sanctions in response to Iranian nuclear weapons development has lead to Iranian threats to close the Straits of Hormuz. Energy markets ignored Iranian threats last week, as energy moved with overall risk sentiment rather than Iranian announcements.

A closure of the Straits is not in the interests of the West or Iran. Iran would lose revenue from loss of 18% of its crude sales that go to the EU that must now be sold at lower prices in Asia.

According to OPEC, Iran gets 80 percent of its foreign revenues — around $100 billion over the past year — from oil exports. The country’s budget has been calculated on the basis of 10,500 Rials to the dollar. Current market exchange rates are 17.8K Rials – a massive potential hit to Iran’s budget from rising costs of dollar based imports.

Meanwhile most of the world would get hit with higher energy costs as their economies struggle. About 20% of global oil and 30% of LNG flows through this waterway, 70% of the UK’s LNG imports and over 80% of India’s.

Sanctions against Iran have sent its currency into freefall, prompting Iran’s central bank to attempt imposing a variety of capital controls. The Iranian Rial is off 40% vs. the USD in just the past month.

Potential for flare ups remain, as Iran vows to continue naval exercises in the area, while the US and Israel announced their largest joint military exercise in the coming week.

Lessons & Ramifications

Our bearish bias remains, despite our noting last week that many leading analysts see stocks flat to higher over the coming year. We are reluctant to take a 5-7% gain from share appreciation or dividends in exchange for a risk of much deeper losses from another market pullback. We agree, however, that those unable to accept low rates offered by quality bonds would do better in equities with sustainable, relatively high dividends, as long as they invest with cash not needed in the coming 24 months.

Continued failure to resolve the EU crisis continues to be the primary market mover, capping risk asset rallies at near term technical resistance.

USD is benefitting from both positive US data, as well as EUR troubles. Evidence suggests that despite the EUR’s oversold short term technical picture, there are sound arguments that it could easily test 1.2000 if not lower to test 1.1000 or even parity, as the EU crisis continues. Risk currencies remain a sell on rallies.

Gold bounced higher last week despite USD strength, suggesting both technical support and EUR weakness causing EUR holders to covert the EUR’s to gold despite the EUR’s short term technical oversold condition. Given the bias of central banks to further easing and gold purchases on dips, we watch for further signs of gold price stabilization before resuming new longs. In the long term prolonged easing and additional stimulus like the ECB’s latest LOTR program and GIIPS bond buying threatens to raise inflation fears and gold demand. In the nearer term, however, threats of new bouts of EU induced panic suggest risk of additional demand for cash, especially the USD, which could pressure gold.

Disclosure/disclaimer: No positions. The above is for informational purposes only. All trade decisions are solely the responsibility of the reader.