The past few weeks have been a total reversal from the sanguine market action of early 2012.
Let's take a look at the events that are currently relevant to day-to-day market action:
- Spanish 10 year yields approaching 7% (currently at 6.66%)
- Italian 10 year yields crossing over the 6% mark
- Spanish bank insolvency, particularly Bankia: The market is looking for a resolution as to how Spain will provide funding to not only Bankia, but future losses in other big banks
- Rapidly deteriorating European economic data: EU PMI showing an increasingly contractionary trend
- Slowing Chinese economy: HSBC PMI is still contracting, bank lending still sluggish despite RRR cut, no plans for large scale stimulus
- The weakness in the Euro currency,
- Questionable U.S. macro data: GDP 2Q print possibly under 2%, stagnant jobless claims around 370,000 level, sluggish job creation
- End of operation twist and potential Fed action: With oil still around $90 per barrel, can the Fed get away with the ill effects of stimulus (higher gasoline prices), especially in an election year? Furthermore, the Fed risks its credibility if it stimulates so close to a presidential election
- Potential ECB action: It is clear that after a few months, the positive effects of the LTROs wear off. The question remains: is the ECB willing to accept even worse collateral in exchange for its 3 year cash? Logistical issues are present.
Market Action
Equities are in a classic downtrend, with a few heavy days of selling followed by the occasional low-volume bullish retracement. Even after Wednesday's heavy selling, the market remains only slightly negative for the week and there are no signs of capitulation present.
Spanish and Italian bond yields have risen relentlessly, now that the LTRO carry trade is over and Spanish bank insolvency has gripped the market.
The euro's slide has accelerated as of late since breaking the $1.25 support barrier. "Oversold" or not, the market is sending a clear sign: capital is flowing from euro denominated assets to those priced in dollars. Why would this stop in the current environment? It won't until market participants fundamentally shift the way they are perceiving the euro's risk.
Correlations have picked up considerably as of late, with Wednesday's credit-equity correlation peaking at the close:
Additionally, the S&P (SPY) is getting ready to test the ultra-important 1,300 support level after breaking through 1,311.
Market Outlook
Global markets are dealing with several key issues right now, and with most European countries in full-blown recessions, China, Brazil and India slowing considerably, and America's own economy in jeopardy of showing sub 2% growth, markets are particularly vulnerable.
The euro has been a key driver of risk recently, and the currency has plenty of room to fall. There is simply no catalyst to get investors interested in Spanish debt, with the exception of central bank intervention, if that's even possible. Markets have become aware of the ECB's dilemma: Another LTRO would require the ECB to accept weaker collateral, particularly from (basically) insolvent Spanish banks. Spain suggested that it load up its banks with the nation's bonds, which would then be used as collateral. The ECB essentially responded with a resounding "no."
Now that Bankia is under Spanish control, and there is a 20 billion euro capital shortfall, where is the cash going to come from? Finding enough organic demand to float that much in sovereign is obviously unlikely, and would result in much higher yields. The only remaining "solution" is an issuance of equity; Bankia is going to have a tough time convincing the market that their assets are worth what they say.
So, what we're left with is the probable collapse of Bankia. It may take a while, but unless the ECB or Fed changes the rules of the game, it's done. After Bankia, you can pretty easily assume Banco Santander (STD), BBVA (BBVA), and other eurozone banks will be at risk of deposit runs.
Conclusions
Essentially, the relatively orderly market decline we've had over the past few weeks has been held together by one hope: coordinated, unprecedented central bank action.
This shouldn't be discounted; it's obviously possible that central planners will find a way to kick the proverbial can just one more time.
However, if they can't, the speed at which our over-leveraged system could unravel is rather incredible. The market remains somewhat hopeful that leaders can work out some sort of legitimate restructuring plan with the possibility of central bank easing aid. I remain skeptical, but share this sentiment.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
Additional disclosure: I am long 10 Year September U.S. Treasury Futures
