With the Fed in the rearview mirror, the market is now free to get back to its daily business of finding ways to dismiss reality by grinding higher in the face of economic news that is bad and news out of Europe that is worse. This may prove more difficult now however, as investors will find it harder to justify bullish positions by reference to the possibility of imminent Fed easing.
That said, Thursday brought no respite from poor economic indicators as the Markit 'flash' manufacturing Purchasing Managers Index hit its lowest level in nearly a year at 52.9, thanks in no small part to the weakest demand from overseas since the financial crisis. New export orders were 48.9%, an important figure given that readings under 50 indicate contraction. Additionally the employment component of the index fell to its lowest level in 8 months. As an interesting and related side note, German PMI fell in June to its lowest level in 3 years, suggesting manufacturing is crumbling in the only healthy economy the EU has left.
In other economic news Thursday, jobless claims hardly budged last week falling just 2,000 to 387,000 missing economists' forecasts of a drop to 380,000. This is the seventh straight miss for jobless claims, as the four week moving average hit 386,250, the highest level since last year.
If those two data points weren't enough to put a damper on the markets, the Philly Fed printed at -16.6 on expectations of unchanged, the worst reading in nearly a year, and existing home sales fell 1.5% last month.
Across the Atlantic, the situation gets materially worse by the day. Spain sold 2, 3, and 5 year paper Thursday at an auction which saw solid demand (bid to covers were higher), but which also witnessed the Spanish government being forced to pay a record 6.072% for note due in July of 2017. Keep in mind that 6% would be high for a 10 year note, let alone a five year bond. Spain can only keep this up for another few months before a full-on bailout will be necessary.
Meanwhile, Italy is pushing Germany to back a renewed push into the sovereign debt market by the ECB (which hasn't bought sovereign bonds in 3 months), this time via the European Stability Mechanism (ESM), a decidedly poor idea as any debt bought by the vehicle would automatically become senior to that held by other bondholders as demonstrated by Spain's bank bailout. In other words: this would be yet another example of the solution being worse than the problem in Europe as bond purchases by the ESM would drive-out all outside demand for distressed sovereign debt.
As borrowing costs continue to rise for Spain, one problem, as I noted in a previous article, is that the ECB has accepted Spanish government debt as collateral for LTRO loans to Spanish banks, a decision which could end up costing the banks dearly, as all three ratings agencies now have Spain at BBB+ or below, necessitating haircuts on all maturities of Spanish bonds held by the ECB and, in turn, triggering margin calls on the pledging banks. The ECB has now figured a way out of this predicament and it is completely absurd: the European Central Bank is considering using its own ratings for the debt it accepts as collateral:
The European Central Bank is discussing a medium-term plan to scrap rating rules on eurozone sovereign bonds and instead set their value when used as collateral in lending operations on its own internal assessment, central bank sources said.
So just to be clear: the central bank will make up its own ratings for sovereign debt (ignoring the opinions of the ratings agencies), use these new 'ratings' to justify cheap loans to struggling financial institutions which can then turn around and buy-up the distressed debt of their sovereigns, which, thanks to the ECB, won't be so distressed anymore. This is the circular 'bank-central bank-sovereign' relationship taken to its logical extreme. If this pans out, there will be no outside, objective influence on the European financial system at all. They will be able to finance themselves right into oblivion, and austerity will continue to be left by the wayside, as countries will no longer see why it is necessary to be fiscally responsible if the ECB will simply ignore irresponsibility when it becomes inconvenient in terms of countries' ability to borrow.
In sum, the economic recovery has all but ground to a halt and the Europeans policy responses to the debt crisis are becoming more inadequate and more frighteningly absurd by the week. Investors would be wise to recognize the fragility of the current situation. Short S&P 500, short Nasdaq, long volatility.