Part 1 of Weekly Review/Preview: Prior Week Market Movers & Their Lessons For the Coming Week
The following is a weekly summary and strategy guide for traders and investors, covering prior week's market movers and their lessons for the coming week for traders of all major asset classes via both traditional instruments and binary options.SUMMARY
1. Greek Debt Swap & Default: The Real Problem Is Contagion
2. US Jobs Data & Preliminary Related Reports
3. China, EU Data, Technical Resistance Prompts Monday-Tuesday Pullback
4. Lessons & Ramifications
Risk assets were lower Monday and Tuesday on poor China data and anxiety over the Greek debt swap's risk of becoming a disorderly default and sparking a sharp pullback. However by Wednesday confidence in both the debt swap and the monthly US jobs reports Friday kept risk assets moving higher from Wednesday onward. Reports Thursday of a potential cut in lenders' required reserve rations by the PBOC also helped.1. Greek Debt Swap & Default: The Real Problem Is Contagion
For most of the week this was the big market mover. We'll skip the details that have been well covered elsewhere and focus on the big point that most writers appear to be missing and its ramifications.
In short, it's the contagion threat, not the actual losses from the Greek default that are the real danger. In brief, here's the problem and what it means for the coming week and beyond.
After much drama, Greece did the expected thing and defaulted on its bonds.
Both traditional and online media were ablaze with declarations that the EU crisis was at least deferred if not practically resolved. We doubt the markets will buy this line for long. Why? In short, holding GIIPS sovereign or bank debt has now become much riskier. That means borrowing costs for these nations and their banks, possibly for the entire EU, must rise to compensate for increased risk.
Here's how the risk as increased.A New Precedent For Defining "Voluntary" Losses That Raises Risks, Yields For All
First, we now have a dangerously unrealistic precedent for what constitutes "voluntary" that will be used to avoid declaring bond defaults in the future.
Theoretically over 80% of bondholders voluntarily accepted the likely 90% loss, obviously because the alternative was 100% loss, making the bond swap no more voluntary than a confession obtained under threat of torture or death, thus setting the very dangerous precedent that such coercion can still be considered voluntary. That means the chances that CDS (bond insurance) hedges will work are lower, and so sovereign bonds are now riskier. That precedent will at some point come back to haunt the EU as bond markets now see greater risk in GIIPS sovereign bonds (and any others that are believed to be at risk), and will demand higher yields in the future.
That point may come as early as this week. In July 2011 we saw how quickly credit markets adapt to increased risk of loss when the EU changes the rules in the middle of the game. Until July, bond markets mostly assumed the EU would never bite the hand that feeds it by inflicting losses on GIIPS bondholders. When it did, yields on GIIPS sovereign bonds spiked, EU banks suspected of exposure to these bonds (virtually all of them) suddenly had to pay more for overnight loans (if they could get them at all), and for the first time in the crisis, Italian and even French bonds yields began spiking, as contagion officially arrived at the core funding nations.
If July 2011 is any guide, we could easily see a fresh wave of spiking yields as early as the coming weeks unless the EU has also learned the right lessons and is ready with new confidence restoring measures. So far, its declarations of victory suggest otherwise.
In short, the EU debt crisis is now harder to solve, not easier. Either the GIIPS, the EU banks holding their bonds, or both, will need to pay more to borrow on the open market, or they will remain dependent on the ECB and assorted forms of ECB money printing. How long do you think the Germans, Dutch, and other fiscally sound nations will tolerate their savings being devalued to save the GIIPS?Haircuts More Likely For Other GIIPS Bondholders
Contrary to the claims of some EU leaders like IMF Chief Lagarde and French PM Sarkozy, there is no reason to believe that haircuts on Greek bonds will a one-time event, neither for Greece nor the rest of the GIIPS.
Before even considering the effects of spiking borrowing costs arising from the Greek default, it's likely that both Spain and Portugal are already too far gone for their bondholders to avoid a similar beating, and though Italy and Ireland might be able to avoid a default (regardless of what the ISDA, the body that officially rules on defaults) calls it, we doubt they'd have sufficient motivation as the precedent repeats.
Obviously there are many nasty ramifications stemming from a wave of such defaults. The most obvious is that the ability of EU banks or anyone else with perceived exposure to GIIPS bonds will be further cut off from access to credit and liquidity that doesn't come from the ECB's printing presses.Uncertainty From Unknown Third Party Risks
While the press has noted that there is only about $3 bln of net CDS exposure, the gross amount (before you net out who owes who) is estimated to be around $60-70 bln. That means the there could easily be numerous third parties rendered insolvent by losses from Greece, and possibly fourth parties rendered insolvent as the dominoes start to fall. The mere uncertainty alone could be enough freeze up credit markets. It's too early to tell. However remember that we're just talking about the ramifications of the Greek default. What happens when Portuguese bondholders also get hit, never mind those of much larger Spain and / or Italy?Damage From Greece Not Over
A lesser point worth noting is that we're far from done with Greece. First, Greece additional Greek defaults or bailouts are virtually certain, with each one raising the chances of contagion as described above. Secondly, Greece's net debt load has barely changed! It got rid of €105 bln in shorter term, higher yield debt in exchange for taking on about €94 bln longer term lower yield debt. That does buy Greece time and might be a solution IF it can grow enough to pay back what it owes. However the Greek economy is still shrinking at an accelerating rate. Unless that situation turns around dramatically in the coming decade, we may simply be looking at a bigger default greater damage in the future.
2. US Jobs Data & Preliminary Related Reports
For the 3rd consecutive month the US added over 200k jobs, adding 227k vs. about 209k. While this was only a modest beating of expectations, an upward revision to January's blowout figures from 243k to 284k confirmed a bullish reaction to the news.
For stocks and other risk assets, the affects of the report were positive but a bit subdued because it reduced the chances for additional stimulus coming from the Fed, creating a "good news is bad news" effect.
However for the USD the effects were immediately positive. The lesser informed may have found this surprising because market observers have become accustomed to seeing the USD move opposite risk assets. However as we've pointed out in the past, the inverse correlation between the USD and risk assets is not ironclad, and indeed often breaks down if good news for risk assets also does one or both of the following:
- Reduces the chances for more stimulus. Stimulus is seen as potentially dilutive for USD purchasing power and so anything that lessens the chance of QE 3 strengthens the USD.
- Raises expectations for interest rate increases. Whenever that happens, a currency tends to rise because rising rate expectations increase demand for a currency for a variety of reasons that we'll leave for now.
A strong monthly US jobs report accomplishes both.
At minimum, just remember that the inverse correlation between the USD and risk assets is complex and far from fixed.
While the ongoing EU troubles (far from over) and job figures should give the USD a boost, investors should not be too overweight in USD denominated assets - nor in those denominated in the EUR, JPY, GBP and most others not backed by national balance sheets with low debt and sustainably low debt and decent growth.
Because the policies of most developed economy nations and currencies (USD, EUR, JPY, GBP, AUD, ETC) endanger the long term purchasing power of these currencies, everyone needs to hedge currency risk. Everyone needs to ensure their portfolio is diversified into the strongest currencies just as it is into the strongest sectors.
FYI, I discuss these topics, as well in depth in my book, The Sensible Guide To Forex: Safer, Smarter Ways to Prosper from the Start. See: http://www.amazon.com/Sensible-Guide-Forex-Smarter-Survive/dp/1118158075 for a more detailed description of how it helps both aspiring forex traders and long term investors seeking to hedge currency risks to survive and prosper in the coming years.
3. CHINA, EU Data, Technical Resistance Prompts Monday-Tuesday Pullback
Disappointing data from China and the EU, combined with some technical resistance, sent markets lower earlier in the week, though from Wednesday on growing optimism about a Greek deal and the US jobs reports supported a rally that left most indices with a slight gain overall for the week. In addition, reports that the PBOC might cut lender reserve requirements, thus freeing up cash for loans, helped boost markets Thursday, particularly in Asia.
Lessons & Ramifications
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Much of the lessons and ramifications were covered above. They were:
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