Prior Week: EU Summit Failure, Bond Price Bounce

|
Includes: DIA, QQQ, SPY
by: Cliff Wachtel

Part 1 of Weekly Review/Preview: Prior Week Market Movers & Their Lessons For the Coming Week

Summary

Risk assets fell Monday through Wednesday as markets digested the hard truth that the EU Summit last week failed to provide meaningful progress towards a solution to the EU sovereign debt and banking crisis. A symptom of this was a steady stream of sovereign and bank credit downgrades or warnings of them. Some decent US data and a modest drop in Spanish and Italian bond yields prevented further declines Thursday and Friday.

However, just as we noted in last week’s review that delayed reaction the EU Summit’s failure could be the big driver in the coming week, we suspect the Fitch’s bombshell announcement Friday, discussed below, could well be the big driver behind further declines this week.

Further risk asset rallies are likely to be short term within a longer term continued decline.

Technical Picture

Turning to our risk asset barometer, the S&P 500, the weekly chart below tells us the following.

ScreenHunter 02 Dec 17 21 12  Prior Week Market Movers: EU Summit Failure, Bond Price Bounce

S&P 500 WEEKLY CHART 02DEC 17 2112

  • The long term downtrend continues with yet another lower high, the fifth since the October rally ended.
  • The simultaneous formation of higher lows, combined with the bearish fundamentals discussed below, lead us to conclude that once we get past the low liquidity year end gyrations, risk asset markets will resume a more serious leg lower.
  • Our likely signal will be when the index drops to test the 1100 level, which opens the way for a test of the EU crisis lows of the spring of 2010.

The daily chart shows a steady decline from Monday through Wednesday, followed by a stabilizing and modest bounce Thursday and Friday. This week’s 2.8% decline in the index well reflected the pullback in other risk assets like risk currencies, particularly the EURUSD (- ~2.3%), and though commodities were the biggest losers, with oil down about 5% and precious metals down about 7%.

ScreenHunter 01 Dec 17 19 57  Prior Week Market Movers: EU Summit Failure, Bond Price Bounce

SP 500 DAILY CHART FOR THE PRIOR WK ENDED DEC 16TH 01DEC 1957

Fundamental Picture

Here’s our summary of the fundamentals behind these moves, and the lessons implied for next week.

1. Disappointment On EU Summit Last Week Keeps, Raises Threats Of Intensifying EU Crisis

We noted in our prior weekly review that the big market mover this week was likely to last week’s EU Summit failure, or more precisely, the market’s reaction to the growing realization of that failure. There really is no practical solution for maintaining the EZ and EUR as we know it. There are plans, but none are acceptable to all relevant parties because they all involve one of the following that are unacceptable to at least some of the EZ members:

Unacceptable to Creditor Nations And Private Sector

  • Relatively healthy EU economies jeopardizing their own credit ratings to guarantee GIIPS bonds against increasingly likely defaults. So far there is no sign of that happening, as German, Dutch, and other strong economy leaders have made clear.
  • Somebody is actually buying those bonds for more than they’re worth given that default risk. Despite the theoretical rejection of PSI (private sector intervention, aka haircuts to private bondholders) from the summit, most understand that, realistically, these are inevitable. There are at least a few GIIPS nations that can’t repay their debts, and whatever concessions they’re granted will be demanded by the rest. We got a stark reminder there are limits to how much austerity and debt payments the GIIPS will accept from a report from the Telegraph last Thursday that the that Portugal’s Socialist Party VP was threatening both default and a union of debtor nations to negotiate at least a partial default.

Unacceptable For Debtor Nations

Ongoing and increasing austerity with no end in sight as GDP declines at least as fast as debt, sending these nations into a self-reinforcing tailspin of lower growth and more spending cuts.

Likely Unacceptable To At Least Some Of Both Creditor And Debtor Nations

Relinquishing control over their own budgets to a centralized EU bureaucracy

The Biggest Story Last Week: Fitch Threatens Widespread Downgrades Because EU Crisis Unsolvable

The event that summed up the situation came Friday when Fitch announced that it’s putting the ratings of Belgium, Spain, Italy, Cyprus, Slovenia, and Ireland on credit watch negative. It soon afterwards added France to that list, given the “heightened risk of contingent liabilities to the French state arising from the worsening economic and financial situation across the Euro zone.”

The really threatening part of the announcement was the forecast that a comprehensive solution to the crisis is “technically and politically beyond reach.” All true, but no one this isn’t some fringe blogger or other fringe type. This is the first time one of the 3 major ratings agencies has publicly said it’s giving up on the EU and EUR’s survival as we know it, under the current circumstances.

Here’s the key paragraph:

Fitch has concluded that a ‘comprehensive solution’ to the eurozone crisis is technically and politically beyond reach. Despite positive commitments by EU leaders at the Summit, notably the decision to accelerate the creation of the European Stability Mechanism (ESM) and to place less emphasis on private sector involvement (NYSE:PSI), the concerns held by Fitch prior to the Summit remain pressing and have not been materially eased by the Summit outcome…Of particular concern is the absence of a credible financial backstop. In Fitch’s opinion this requires more active and explicit commitment from the ECB to mitigate the risk of self-fulfilling liquidity crises for potentially illiquid but solvent Euro Area Member States (EAMS).

In sum, defaults, banking crises, further deep global recession are coming; it’s just a question of when. See here and here for further details.

This announcement contrasted sharply with the steadying of risk asset prices Thursday and Friday, based on the spreading belief that the ECB’s latest measures to make it easier for banks to buy peripheral sovereign debt were producing results.

Let’s look at that.

2. Falling GIIPS Bond Yields Prompt ECB Stealth Bailout Speculation

Falling Italian and Spanish bond yields prompted speculation that they ECB was easing collateral rules so that banks could use GIIPS bonds as collateral to buy…more GIIPS bonds.

Pros

The reason this might work, at least in the short term, is that the ECB would increase demand for GIIPS bonds by funding these purchases at rates far below what these bonds paid, allowing banks an easy profit on the difference.

If that prompted increased demand for these bonds, their yields would fall, the GIIPS could regain access to affordable credit, and the threat of default would recede. See here for more on this.

Is that profit worth the risk of default? Yes, if the banks believe any of the following:

  • There won’t be a default
  • If there is a default, the banks either will be compensated for their losses, bailed out, or in some other way be rescued from the consequences of their own actions by the taxpayers.

Cons

Please, you can’t be serious. The creditworthiness of the GIIPS hasn’t improved at all, nor has the risk of a Greek default and the wave of sovereign and bank defaults that would follow. So why should confidence in GIIPS debt improve?

Without a permanent guarantee against losses, it’s hard to see banks further risking their solvency by buying GIIPS bonds in the quantities needed. So far we see no such promises offered. Even if they were, could a responsible banker believe them, given:

  • The EU’s current track record for managing this crisis
  • Fitch’s conclusion that there is no solution to the crisis as noted above.

See here for more.

Noteworthy But Not Market Moving

  • FOMC: No New Stimulus For Now: The FOMC showed no sign of offering further stimulus this week. This wasn’t a surprise, but markets still didn’t like it.
  • Decent US Data: US data came in overall better than expected.
  • Baltic Dry Shipping Index Rises: The latest figures refute China collapse worries.

Lessons & Ramifications

The above all point to the same conclusions:

  1. The overall direction for risk assets remains down. The more exposed to an EU collapse, the greater the risk. Unpredictable political decisions will determine when that comes, so timing this is difficult. Those taking positions in the likely winners of such an event (shorting major EU banks, the EURUSD, EURJPY, etc) will need to be able to ride out volatility from assorted hope based rallies, bailout rumors, etc. In the end, there’s too much pain involved in preserving the EU in its current form unless EU leaders can completely circumvent their own parliaments and voters. Not likely.
  1. While precious metals should ultimately benefit from the money printing to come, wait for the current down trend to reverse, as crisis fears could continue to drive them lower as liquidity remains a higher priority than currency hedging.
  1. EU crisis headlines remain by far the big market mover to watch. As the NY Times reported this past week, Professional market watchers are adapting their work hours to monitor European market events. In particular, look for debate next week about Fitch’s terminal prognosis of the EU to sway markets.

Disclosure/disclaimer: No positions. The above is for informational purposes only. All trade decisions are solely the responsibility of the reader.