That the US and the global economy are moving towards stability has been indicated by rising oil and base metal prices as well as the stock market performance from the middle of March 09. The surprising jobs data at a job loss of 345k against a much higher expected number did reaffirm the fact that the US economy is moving back to normalcy, the stock market reaction, which one would attribute to such a margin of surprise, was missing. Clearly this seems to have some other implications which the players are factoring in.

Explanations could be along these lines:

Funny are the ways of Street…but the Street is most honorable…and it cannot be wrong…never fight Mr. Market. If you do you would be mauled. But in 2007, those who went against the street benefited the most. The Street does lose its head, and there are those phases when not all the facts/news is factored-in. The art is to figure out when Mr. Market would look to redeem the honor. This becomes all the more difficult when the stakes of the mighty are involved, and for some period, they are able to manage the Street to their ways. With the bank stress test climax, the stress test for the Street has begun.

NYT reports:

The feel good factor is back. Many experts opine that we have indeed put in a bottom and that with due corrections we shall now march upwards. The fact that most were talking about a recovery that would be shaped L, U, W etc., contrary to the expectations as markets usually do, many experts think the market in its wisdom has sought a V shaped recovery. Even the bulls have been taken by surprise at the swiftness and the ease of the up move. It started as a short covering in financials following the leak of Citi’s (C) internal memo stating profitable operations with BofA (BAC) backing it up and Wells Fargo (WFC) following it up with a pre-result announcement, and it appeared a well coordinated effort.

And then there was this panic that set in – panic buying. To me this appeared to be a well prepared script. When you have to move anything heavy, say a huge log, the initial efforts are huge, and once it rolls, it rolls with a slight push thereafter. Once the shorts covered, the institutions which had their hearts in their hands and have been funded by the taxpayers’ bonanza needed the market to cut back its negative bias, and were probably instructed to move it. Sentiment is a great player in how things shape up, and to prop it up is surely the main focus. Once moved, there were others who had the urge to take risks, and the scampering started.

The banks got it finally as lawmakers literally forced FASB to relax the fair value or mark-to-market rules and the market celebrated it as if by wave of magic wand all the underlying risk has magically vanished.

The Bloomberg report (linked above) says:

I understand we have had a 3-week rally of proportions not seen since 1938 in the US. On a weekly basis the Dow closed up 6.8%, the S&P 500 6.2% and the NASDAQ 6%. On a monthly basis till now the Dow is up 10.1%, S&P 11% and the NASDAQ 12.2%. The real push came when the Fed announced that it would buy $300 billion in Treasuries from the market over the next 25 weeks or so to help support the economy and spur lending. Also the program to buy housing agency debt and mortgage-backed securities was extended to about $1.45 trillion.

Following this, Treasury prices surged and 10-year yields plunged about half of a percentage point, the biggest drop since the 1987 stock market crash. Also the US dollar plunged. This resulted in commodities, mainly base metals and oil, moving up and as the shorts covered the up move was magnified. The Geithner plan to handle bank toxic assets was also well received, which gave more teeth to the rally.

For the uninitiated here is a Wikipedia snapshot of CDS:

A credit default swap ((CDS)) is a credit derivative contract between two counterparties. The buyer makes periodic payments to the seller, and in return receives a payoff if an underlying financial instrument defaults.

The headlines are becoming so depressing and their ‘we've given up’ tenor is making me believe that the bottoming process has started. By no means am I trying to predict the bottom or for that matter say that the worst for the markets is over. I am starting to sense now that the second half's recovery theme is history. The tone of the optimists tends to say – ‘we probably underestimated the depth of the problem.’ And now the depth of the problem and the issues, to me, is getting a slow but definite over-extension to the other side. The sense of gloom being predicted smells of converts and the conversion rate is accelerating. Sample this:

1. Financial Crisis sparks unrest in Europe

The decoupling theory – Asia and Asian markets (sans Japan) decoupling from the rest of the world – keeps surfacing from time to time – specially when the markets in Asia tend to perform better than those of US and Europe. It happened in the first two weeks of February when the Chinese and Indian markets seem to have started outperforming the US and European markets. However as the US market indices have started to challenge the November 08 lows the perception seems to be altering again. So is decoupling a possibility at all?

Prima facie it appears to be a difficult proposition. The reasoning is very sound:

Last week’s market reaction is attributed to the lack of details in the Geithner proposal. The basic issue revolves around the valuation of the bad /toxic assets. A low price while taking the asset of the bank balance sheet will also cause further charges to be taken and may require further capital. Bloomberg quoted an expert saying that … “Through this whole process, it seems as if the government needs to take a course in marketing.” It is unclear if he will come out with the details.

Thursday’s movement of US stock prices will tell us a lot about it! Just when one thought that the supports were to give way the market rebounded and bulls took-off.

The logic in the currency markets usually has been: sell lower interest rate currency and buy higher/stronger rates. The strategy seems to have reversed now – low/zero yield seems to positive.

When in Prague the Czech central bank slashed its interest rates to an all-time low, the Czech Koruna actually bounced vs. the Euro...

The proposal to take the toxic/lousy assets of the US banking system into a ‘bad bank’ and leaving the performing/good assets with the existing banks had initially received a positive response from the street. But investors have been wondering how to value these assets.

As one expert explains:

Look at the highlighted rows in the following tables. As regards WTI (West Texas Intermediate) and Brent the large contango or forward premium is the order. Furthermore, the difference between the near/front month contract between WTI and Brent shows a $10 difference. This is staggering. It may also be noted that the differential in the December contracts are minimal.

For those who may not be clear on the difference between WTI and Brent:

Having looked at the possible developments in China, the latest news out of the rest of Asia is also not good. Factory output in Japan fell more than 8% in November, the biggest drop in 55 years. It is also expected that Toyota (TM) may report the first ever loss since WWII. According to a Bloomberg report:

Japan's economy will probably shrink at an annual 12.1 percent pace this quarter (ended Dec 08), the sharpest drop since 1974, as exports collapse…

The eurozone has put together its own stimulus package. Given the nature of the union, where each country has its own typical problem and the political setup has to address its own constituencies, it will be interesting to watch how the union overcomes these issues keeping its common interest in view. DB research observes:

At their recent summit the EU heads of state and government adopted the European Economic Recovery Plan put forward by the European Commission in late November. The 27 member states aim to raise 1.2% of GDP, or EUR 170 bn, to fight the recession in Europe (another EUR 30 bn will come from the EIB). The member states are free to choose instruments from a fiscal tool box in order to stimulate growth in their (national) economies. The EU has merely a coordinating role. This approach makes sense for two reasons: one is that the economic problems in the member states have quite different starting points. For instance, the United Kingdom and Spain are confronted with a serious crisis in the real estate sector, while Germany has to grapple with a slump in foreign demand. The other reason, though, is that in a single market with close economic ties it is vital that national measures do not cancel out the efforts of other member states and that these other members do not remain idle in hopes of benefiting from the economic policies implemented by their partners.

China showing any signs of bottoming out is a function of how its exports perform. Reports say:

…China’s growth may have slipped to 5.5 percent last quarter, the weakest pace in at least 15 years, as recessions in the U.S., Europe and Japan cut demand for exports, according to Shanghai- based Industrial Bank Co.

What will dominate when the US Treasury bubble bursts?

The good news:

…When the Treasury bubble does pop, it will likely be a sign that the economy is turning around and that credit is more available again, experts said. People will sell off their Treasury holdings because they think that stocks and corporate bonds will offer better returns….

The Economist explains to why corporate bonds should probably rally before a genuine rally in equities begins.

A further dilemma is whether corporate bonds will rally before equities. That would seem logical, given that bonds have a prior claim on corporate profits. In addition, companies seem likely to run their businesses for the benefit of bondholders rather than shareholders, cutting dividends to save cash, for example…there may be a selection problem: weak companies have tended to borrow, and there are very few AAA-rated companies these days. Many of the most heavily-geared companies are in the portfolios of private equity groups, rather than on the quoted market.

By subtracting the yield of TIPS (Treasury Inflation Protected Securities) of a particular maturity from the yield of an ordinary Treasury note/bond of the same maturity, you obtain the implied annualized inflation over the time to maturity.

Treasury Yield Curve (%)

Americans are starting to save again rather than relying on capital gains to do their saving for them. The government says Americans set aside $260 billion from their disposable incomes in October, up from about $70 billion a year earlier. That's a step in the right direction for the long term, even though it intensifies the short-term downward pressure on the economy because consumers aren't spending.

The effort to save more amid weak income growth and tight credit will prevent consumers from providing their usual oomph to the recovery. As a result, businesses will not be as quick to expand.

With a 35% drop in sales reported by the big three auto companies, the financial stress on them has only increased further. This will have its impact on employment as production is reduced. According to the NYT, GM’s (GM) chief market analyst, Michael C. DiGiovanni, said that the automaker was predicting industry sales of 10.5 million to 12 million vehicles for the year.

The company recently received federal loans which provided some confidence to the market. The US automaker bailout is trickier than it may appear. The conditions that have been imposed - as an expert observed - are “structured for bankruptcy”. By end of March the company will to prove that it is viable. By this time it needs to negotiate with its creditors to have its debt modified or reduced by two thirds at the minimum. It also needs to have new agreements with its vendors with new conditions more favorable for it. The compensation and benefits of workers and executives also needs to be lowered. If it is viable and if it is able to deliver, it needs to repay the loan. Most observers doubt if this can be achieved in such a short period. This would then result in a pre-packaged bankruptcy. GM's only hope is for Obama to show it leniency.