Thursday's Market - The Real Problem Is in Europe

Includes: ERO, EU, FXE
by: Bernard Thomas

Did we all have fun Thursday? First we had Greece doing its best to kill itself. Then when the market was in full panic, the machines took over. At approximately 2:40 PM EDT, the DJIA suddenly dropped about 700 points for at total of 1,000 points for the day. Stocks such as PG dropped below $40. Some printed in the pennies then as quickly as it started, the market rebounded almost all the way back to where it was about 20 minutes prior. What happened?

Computers are what happened. As the pace of orders quickened, the NYSE's systems are programmed to slow down. This means that they basically halt trading for 30 seconds to a minute. However, stocks do not trade only on the NYSE. NYSE listed stocks also trade on NASDAQ and on ECNs. ECNs (electronic communications networks) are private systems which facilitate trades for subscribers.

However, these trades are reported to the consolidated tape. ECNs are not required to halt trading when the NYSE or NASDAQ does. This makes the ECNs the best bids or best offers. Often the best bid or offer on an ECN is much different than what was last posted on the exchange. Market orders will be executed at the best available price. If one wanted to sell a stock at 2:40 PM Thursday when the exchange took a breather the ECNs did not.

Many market sell orders were sent to ECNs where the bids were low. The low prints set Wall Street firms' computers in motion. Trading in microseconds, they executed literally thousands of algorithm-driven orders in a short period of time, driving the market lower. Once the machines finished selling the farm, the sell side pressure abated and the markets recovered to almost where they had been just prior to the selling frenzy. It appears the NYSE and NASDAQ are going to cancel select trades executed after 2:40 PM.

Although the problems with equity trading systems are newsworthy, the problem lie in Europe and with our shaky recovery. Europe refuses to accept reality. Greece is impaired (I am being kind). It either needs to leave the euro or it needs to restructure its debt. All the reassurances by ECB President Jean-Claude Trichet did nothing to calm market fears, nor should they. The EU IS NOT the United States of Europe. A better description would be the Confederate States of Europe with each member having a strong state government and a strong local identity.

The EU had better act fast to keep Greek problems from spreading. Portugal is ready to fall over the edge into the economic abyss. The problem is with the banks. Banks use their domestic treasury securities as collateral to borrow in the repo market and from the ECB. If their home governments are impaired, the bonds will not be loaned against at their full value. Banks may only have to put up more bonds as collateral for a given amount of borrowing. Europe has problems.

This is not surprising to me. European banks were generally believed to be more damaged from the imploding housing bubble than U.S. banks. There is little dynamism and entrepreneurship in the Old World. Those who believed that the euro would be the next reserve currency after the dollar got a rude awakening in recent weeks.

The U.S. dollar is THE reserve currency. No other currency is as secure and no other economy is as dynamic. This pushed the yield of the 10-year treasury below 3.40%. Does this mean that long-term rates are going to trend even lower? Perhaps for awhile. After all, there are investors such as foreign central banks, insurance companies and various trusts which must own debt. However, other investors can diversify beyond debt and will instead buy gold. This will limit further rate declines.

What this does mean is that the 10-year is not visiting the 5.00% area any time soon. In fact, with poor job growth, strong productivity, and moderating retail sales, combined with lower profits from the stronger dollar, we may not see a 4.00% 10-year this year. The Fed will also remain in the sidelines. Although I don't think we will experience a double dip recession, we could see the growth chart flatten a bit. The lesson to be learned here is that growth from borrowed money can never be considered sustainable.

The bond vigilantes have invaded Europe and are saying enough with throwing money at problems. Enough with not acknowledging losses. Enough with borrowing one's way out of trouble. The same could and would happen in the U.S. except we are the only game in town and major commodities trade in dollars. This means market participants need to own dollars. Only by the grace of the size of our economy go we.

Investors have trouble distinguishing credit products from interest rate products. They believe that all bonds move up and down together. Not so. Corporate bonds and preferreds are credit products and in times of crisis and recovery, credit market yields and treasury yields can move in opposite directions. That is what has been happening in recent weeks.

I have been suggesting that investors sell their long bond and preferred positions unless they absolutely need income. Hold off now. Spreads have widened. I would wait until the next round of recovery. I still wouldn't buy more out on the long end, but maybe hold on for now. Floaters and TIPS should only be used as hedges for specific events and not as opportunities to hit home runs. That would be a low percentage play given what is likely on the horizon.

Disclosure: Long TBT, C, BAC, F, SIRI, FREPRZ