Recently, investors and traders have more or less tuned Europe out. The S&P 500 has risen above its 1,340 pre-summit level, short-term volatility (VXX) has dropped to complacent levels, and oil has jumped above $90.
It's good that the market spent a few sessions without responding to every tick lower in the euro. The recent rally wiped out a lot of shorts and uninvested bears, and returned market emotions to a much more balanced level. That being said, a lot of investors probably missed some pretty big news out of Germany.
For all the gloom and doom the media likes to feed the public, it's quite amazing how little was made of the recent news regarding the German constitutional court ruling on the ESM. As some of my followers may recall, a recent article of mine outlined the ambiguous delay of the ESM due to its review in the German constitutional court.
On Monday, it was announced that on Sept. 12th, the court will decide whether or not to temporarily block German participation in the ESM. With such a large portion of the funds coming from Germany, the ESM participation weightings written into the legislation would make the mechanism illegitimate.
Keep in mind, this ruling will decide whether or not the court will temporarily block the ESM. It will only be after the ruling that Germany's participation will be decided upon.
Markets Suffering From a Lack of Direct Purchases
Spanish yields approached new record highs today, closing at 7.27% on the 10 year. Italian debt didn't fare much better, closing at 6.17%.
The relentless rise in peripheral yields is due to the following: When distressed sovereign debt prices rose in response to the euro summit, they priced in future, direct purchases made via the ESM. Market participants front-ran the purchases, driving down yields and stabilizing global markets.
Now, with purchases delayed until at least September, holders of peripheral debt are getting nervous and dumping the bonds. Being that it's only July, Spanish and Italian yields could easily test 8% and 7%, respectively, by the time the ruling comes. Spain and Italy could fall victim to a complete lack of buyers considering their funding needs. Spain needs to issue another 35 billion worth of euros, and Italy has an absolutely obscene funding need of 120 billion euros.
I don't see how the market is going to absorb another 155 billion euros worth of debt that is widely considered to be "worthless" without EU guarantees.
What Could Actually Happen on Sept. 12th
Should the court deploy an injunction against the ESM, peripheral markets are going to break. Confidence is a fragile intangible; when markets expect several hundred billions of purchases to be made and it doesn't get said purchases, confidence erodes rapidly. The front-run trade won't be there anymore, since it won't be profitable from a risk/reward standpoint.
Even if the court allows German participation, it remains to be seen how quickly the EU can get the mechanism operational. Furthermore, credit agencies are likely to cut Spain and Italy as confidence in the future of the ESM erodes:
Analysts at Moody's Investors Service said in a report Monday that eurozone government debt was 'credit negative' -- a warning against potential future credit downgrades -- because of the delay to launching the bailout fund resulting from the constitutional challenges in Germany.
Conclusions and Strategy
The long-term market trend is still visibly upward. The market was remarkably resilient last week as each fresh bout of selling gave way to intense buying pressure toward the close. As many traders know, when the market doesn't respond to news the way it should, it's probably headed the other way, at least in the short term.
We've certainly seen that. Unwilling to break under the pressure of EU worries and U.S. growth questions, the market has recovered markedly this week, despite today's 1% sell-off.
My feeling, however, is that this market is fundamentally complacent rather than reasonably bullish. While we've started to price in a distressed European economy and weaker U.S. earnings, further deterioration in the global economic landscape has not been discounted into equities.
The whole world isn't going to come apart. However, essentially no one is expecting a major sovereign default and I think this is a mistake. Spain's debt is very close to a tipping point and holders are going to capitulate soon if direct intervention isn't promised in the very near future.
Strong global market rallies this week weren't enough to catalyze buying of Spanish or Italian debt. So what could possibly draw buyers in? With the exception of direct intervention, nothing.
From a risk analysis standpoint, a quick look at U.S. equities and the volatility term structure tells me that regardless of how bearish the treasury and dollar markets are, equity holders do not share the same sentiment. With volatility looking ultra-cheap here, equities have some more discounting to do.
I'm still holding longer-dated puts on the SPY, and have been increasing my exposure.