Very early on Friday morning, US stock futures are up nearly 150 points on news out of the market-saving EU Summit. The key news item:
"Van Rompuy said leaders of the 17-nation eurozone also agreed to a joint banking supervisory body. And he said the leaders of the full 27-member European Union agreed to a general long-term plan for a tighter budgetary and political union."
Markets are jubilant on the news that banks can now receive direct funding from the ESM and EFSF. Wait, but does the ESM even exist yet? (Hint: no). Potentially even more important to markets was this market-ramping headline:
"EU Leaders Renounce Seniority On Spanish Loans"
The change in seniority, of course, being a key reason for Spanish yields climbing above 7% recently. Private creditors were naturally worried about their place in the debt restructuring line when the ESM's credit rights became senior to everything else. If this news is true, then you can at least expect a relief rally in Spanish debt.
Here's how the funding for Spain is now proposed to work:
"We urge the rapid conclusion of the Memorandum of Understanding attached to the financial support to Spain for recapitalisation of its banking sector. We reaffirm that the financial assistance will be provided by the EFSF until the ESM becomes available, and that it will then be transferred to the ESM, without gaining seniority status."
So the EFSF will supposedly hand over to Spain about 80 billion euros (from what coffers, I do not know), the ESM will hopefully be ratified by someone, the assistance will be moved off the EFSF's balance sheet onto the that of the ESM, but the ESM's rights will not be senior to those of private creditors. With no credible plan to get the ESM up and running, this plan will likely fall apart with laughable speed.
The full EU Summit speech concludes with the following:
"We task the Eurogroup to implement these decisions by July 9, 2012."
There's a lot more red-tape to get through still, and this feels like a last-ditch, poorly structured effort to restore some confidence in the markets. Take it for what it's worth; it's clear the EU leaders are folding and are nearing near complete capitulation. Dropping seniority, allowing direct recapitilizations of insolvent banks, removing tough austerity implications for sovereign nations who request bailouts; there's nothing left except for the dreaded Eurobond.
We essentially just saw Europe fire its biggest bazooka yet, and stocks can muster only 1-1.5% gains? Granted, it's still early in the morning and markets could gain strength, but based off what we saw after both the Spanish bank bailout and the Greece elections, markets will probably wise up by afternoon US trade.
There are risks being tactically short in this market. While the EU essentially just showed all its cards, they might create a few new ones out of thin air, if only just to pump the markets for a few hours. It's a dangerous game for the EU to play, but taking the other side has been quite profitable over the last several weeks.
Is This Time Different?
LTRO squeezed essentially all risk out of the system for the 1Q 2012, and global equities and commodities soared. I mention this fact because when the EU successfully kicks the can, it's exceptionally painful for short sellers.
We saw a 400 point day in the green when the Fed cut the rate for dollar swaps, and it also contributed to a sustained rally.
Recently though, the so-called half-lives of these interventions has been extremely weak. The Spanish banking bailout resulted in a big down day, and the reaction to the Greek elections was similar. Both events led to exuberance in the overnight futures markets, only to die off by next day's trade.
Remaining tactically short is still the play here, unless the EU really surprises and gets the ESM 1) ratified, and 2) funded. If those two conditions are met, the ECB might be able to direct the funds right to insolvent banks and nations, though the figures suggest that there won't be nearly enough capital for everyone.
Eventually, someone is going to run the numbers and realize that unless the ECB prints a couple trillion euros, there's not enough cash to set things straight.
Conclusions And Trade Recommendations
Short this morning's irrational exuberance via short futures contracts, or a similar method of choice. The market reaction is telling; a mere 1% pop is quite disappointing considering the excessive pessimism surrounding this particular summit.
Of course, if the fundamentals change, you've got to adapt. An ESM ratification and funding would change the game for another few months, at which time you would be caught off guard.
Additional disclosure: Short S&P Mini Futures