Markets' Surprise Drop Last Week Highlights Changed Dynamics

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Includes: DIA, FXE, GLD, IAU, QQQ, SPY, UUP, VTI
by: Carlos X. Alexandre

Common wisdom tells us that higher inflation warrants higher interest rates, and in turn interest rates trigger currency valuations. Last Friday, the Eurostat, the statistical branch of the European union, reported that the flash CPI for the eurozone was 3%, up significantly from 2.5% last month, and way off the forecast for no change. At the time of the announcement, the euro December futures contract was trading at $1.3539 and then it started to slowly sink, dropping to $1.3472 by 6:30 a.m.

The euro ended Friday slightly below $1.34 for a total loss of 1.1%. The S&P 500 futures followed suit and were already down in the morning due to a variety of overnight factors, such as the manufacturing contraction in Japan with a PMI reading of 49.3. As the euro depreciated further, the equity sell-off picked up steam.

However, if the same announcement had taken place several weeks ago, stocks would have rallied because the euro would have risen – depreciating the dollar – in anticipation of future rate increases by the European Central Bank. And that was the noticeable difference. In other words, and my opinion, the markets virtually stated that although inflation is rising in Europe, they don’t care, especially because the ability of the ECB to raise rates has been removed by a variety of economic factors.

Furthermore, the very fact that inflation increased from 2.5% to 3% while commodities – energy, food, etc. - have dropped considerably since May, brings the data into question, especially when reading the Eurostat’s report (pdf).

To compute the MUICP flash estimates, Eurostat uses early price information relating to the reference month from Member States for which data are available as well as early information about energy prices.

I have not tried to track the source of the inflationary pressures but it may as simple as taxation. As an example, effective October 1st, Portugal increased the value added tax (sales tax) on electricity and natural gas from 6% to 23%, and that is not yet reflected in the inflation numbers. Talk about government induced inflation that makes commodity speculators look tame by comparison. And once again we’re staring at the mentality, blessed by the IMF, that they prefer to suck whatever is left out of society than embrace true reform.

In addition to the ongoing uncertain European debt issues, the Financial Times reported on Friday that “Denmark gives banks $72.6bn lifeline,” a country that is hardly in the news, but in the big scope of things added to negative sentiment.

In essence, Nationalbanken’s move extends a fresh line of credit to small banks that could have faced bankruptcy with the expiry next year and in 2013 of earlier emergency measures. In a significant departure from the existing benchmark on acceptable collateral, the central bank will expand the collateral basis from government and mortgage bonds to include the banks’ own credit claims.

Interestingly, gold futures held their ground on Friday, even in view of a rising dollar. By extension, the SPDR Gold Trust ETF (NYSEARCA:GLD) stopped the bleeding, while the dollar/gold correlation and “instability” gold driver face a renewed test.

Over the weekend three stories regarding Europe stood out. First Bloomberg reported that French President Sarkozy stated that “there’s ‘no credible alternative’ to channeling aid to Greece,” and that will only add to the pile of reasons for capital to exit Europe.

“The failure of Greece would be the failure of all of Europe,” Sarkozy told reporters. “Remember in 2008, when the U.S. let Lehman Brothers fail, the global financial system paid the price. For both economic reasons and moral reasons, we can’t let Greece fail.”

Then according to France24 a contrasting view to Mr. Sarkozy’s statement was delivered by German Finance Minister Wolfgang Schaeuble. He “ruled out Germany contributing any more money to the beefed-up EU bail-out fund than the 211 billion euros approved by parliament, in an interview published Saturday."

"The European Financial Stability Facility has a ceiling of 440 billion euros ($590 billion), 211 billion of which is down to Germany. And that is it. Finished," he told the magazine Super-Illu. He also suggested the European Stability Mechanism, which is due to replace the EFSF by 2013 at the latest, would be smaller.

And as if the previous two stories weren’t enough, the proverbial money pit – Greece – had some news to share as well. MarketWatch reported that “Greek budget falls short of deficit target.”

The Greek Finance Ministry on Sunday cleared an austerity plan for approval by the country's Parliament that falls short of targets set by the European Union and the International Monetary Fund, according to reports on Sunday. The draft budget calls for a deficit of 8.5% of the country's Gross Domestic Product in 2011, falling short of a target of 7.6%, Reuters reported. The deficit will be reduced to 6.8% of GDP in 2012, but still short of the mark of 6.5% of GDP.

To summarize, there’s no credible solution, aid to Greece is capped, and Greece is missing the target. What an inspiring combination. Even the Federal Reserve is getting jittery, according to Bloomberg BusinessWeek.

The Federal Reserve Bank of New York may ask foreign lenders for more detailed daily reports on liquidity as the U.S. steps up monitoring of risks from Europe’s sovereign debt crisis, according to two people with knowledge of the matter.

And the reasons for capital to continue seeking safer pastures away from the eurozone continue to mount. Lastly, the much advertised “summer crash” was already in motion since late April when one looks at the action on a monthly basis, and it was only noticed by the media at large when the wide swings came into play.

And as we start earnings season, the quarterly retirement account statements are being printed and mailed. Although the news media has covered the bulk of the recent macro market drops, only the statements will deliver a personal touch to retail investors, and their reaction as a group is anyone’s guess.

On the lighter side, my 13 year old daughter delivered a sobering perspective when she asked me “Do you know who’s the number one economy?” while we watched the news. “The dead people because they don’t have one!”

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.