Nightmare on Wall Street? Upcoming Bank Earnings Could Rock World Markets

Forget the movies. Forget the roller coasters. This summer’s real excitement: the coming second quarter bank earnings announcements, and their potential effect on world stocks, currencies, and commodities markets.

Having followed all these markets for a while now, it’s a lot like any classic horror or action flick. You know the basic plot, but it can still get you sweating.

Introduction: Chronicle of a Crisis

All major market shifts since 2007 have begun with the U.S. banks. With them the crisis began, with them the rallies began. With them may come the next move down, and only from their true recovery will there arise a genuine recovery. Amen.

Their coming earnings announcements, and the ensuing government responses, are likely to be the economic event of the summer.

Let’s quickly go through a brief chronicle of the crisis:

The current world economic crisis began as a self-inflicted U.S. banking crisis.

The still-alive March rally in stocks and commodities began when the big financial institutions announced first quarter profits. As repeatedly noted by this author and others, this feat required an unprecedented collaboration/conspiracy involving Washington and Wall Street. These profits were not from genuine ongoing operating results likely to be repeated, but were rather a result of a combination of some rather irregular activities, including:

• fabricated hyper-profitable fixed income department trades with AIG, which by themselves were large enough to outweigh the enormous real operating losses
• overstated asset values aided and abetted by bank regulators and the suspension of market to market accounting

When that rally faltered, Washington announced more help in the form of the Public-Private Investment Program (PPIP), another thinly disguised bank welfare program, paid for by U.S. taxpayers. That maintained optimism about the banks, and thus the market, and forced the massive shorts to unwind, thus continuing the low volume meander up to 30% gains.

Within the month, the leading financial institutions on which America depends will announce second quarter earnings. For example, Citibank (C) and Goldman Sachs (GS) are scheduled to announce on July 17th. Rumors and whispered numbers may come sooner. If positive, they will almost certainly be leaked sooner.

Unemployment is already around 10%, well past the bank stress test worst case scenario of 8.9%. That means many thousands more residential and commercial mortgage defaults. Worse, those tests were before GM (GMGMQ.PK) officially rolled over into bankruptcy.

Can Team Washington & Wall Street pull it off again?

Barring some incredible surprise, luck, or creativity (all possible), we think not, and here's what that means:

Scenario 1: Banks Show Losses: Ramifications for World Stock, Commodity, and Currency Markets

Given the above history, if bank earnings disappoint, we can expect some version of the following chain of events: In essence, faith in the fragile, nascent, embryonic world recovery breaks down. From this follows:

A. U.S. stock markets plunge

We get a likely retest of March lows assuming the process hasn't already begun. A brief look at a daily S&P chart () will show the March uptrend has already been decisively broken.

S&P Daily Chart (courtesy avafx.com)

B. World stock markets follow

They have faithfully followed each other through this crisis, and thus can be expected to continue to do so barring evidence to the contrary. After all, the U.S. is still the major customer of the big exporters, including China. Their economies depend on America. For all the talk at the first official BRICs summit, the BRICs will crack without a robust U.S. consumer market.

Think the world can roll along without a sick U.S. economy? This past week both the IMF and the Paris based Organization of Economic Development (OECD) came out with predictions about the world economic situation. The IMF said things were getting worse. The OECD disagreed. What was the basis for their difference? The OECD believed the U.S. would improve enough to make up for the continuing worsening situation in the rest of its member countries.

C. Commodities Crash Too

The ensuing gloom presumes weakened demand for industrial commodities like crude oil, at least in the short term. Deflation becomes a bigger concern than inflation, so the precious metals become less so.

D. Currencies: JPY, USD, CHF Tend to Rise Against Other Major Currencies

Paradoxically, the U.S. dollar actually becomes a short term beneficiary of the pessimism about the U.S. and world economy. For those who don't follow currencies trading, the USD is considered a safe-haven currency in times of fear or "risk aversion,” second only to the Japanese Yen (and then followed by the Swiss Franc).

For example note how the Euro-dollar currency pair EUR/USD (currencies always trade in pairs, since one currency must somehow be priced relative to something else) has behaved since stock markets were at the March 3rd lows, as depicted on the below daily EUR/USD chart (). Note that we read this combination to mean "Dollars per Euro." Thus the rising price of this currency pair mean more dollars per Euro, the Euro is appreciating against the dollar.

EUR/USD Daily Chart (courtesy avafx.com)

Note how when fear was at its highest in autumn 2008 and in early March 2009, the Euro, and all other major currencies (except the Yen), were at recent lows against the USD. As the March rally has progressed, they've generally gained (except the Yen) against the USD, as optimism fed "risk appetite" and currency traders sought higher yielding currencies.

Here's another example, a daily chart of the AUD/USD. Note a similar pattern.

AUD/USD Daily Chart (courtesy avafx.com)

The Australian dollar tends to behave in an especially inverse manner to the USD. Not only does its central bank pay among the very highest interest rates among the major currencies (unlike the Fed with the USD paying among the lowest), Australia is a commodity export based economy. Thus demand for its exports, and for the AUD, varies with anticipated economic growth more than the USD. So when the world economy looks bad, lower exports are anticipated and traders tend to dump the AUD in favor of the USD and JPY. Whether you agree that these are in fact safer or not, that's how traders treat them.

Scenario 2: Banks Post Positive Results: The Opposite Reaction?

Here's where it gets less clear. The short answer is, it depends how positive. If they somehow show profits from ongoing operations that are likely to continue (no, I don't see how either, but put that aside for the moment), then depending on how convincing their ongoing prosperity is, the recovery is likely to be truly under way. If however, the results are mixed, or, as is so fashionable these days "less bad than expected and thus somehow positive" then the picture is murky.

So What Do You Do?

If the banks were left to themselves, the strong likelihood would be scenario 1. But given that Washington can't let them die, the question really is, how much can Washington still do to minimize the damage?

If you believe in Scenario 1: take profits on stocks; consider some kind of short on stocks (buy puts on the S&P or other indices, Ultrashort Proshares for short term hedging (like SDS on the S&P, SDK on the financials). Currency and commodity traders should short commodities, go long USD, JPY against other major currencies, especially the CAD and AUD.

If you believe in Scenario 2: If the mood is very positive, consider buying stocks, commodities, and the higher yielding currencies (AUD, NZD) or commodity currencies (AUD, CAD) against the USD and JPY.

Disclosure: I have positions in most of the above mentioned investments.