‘As expected’ might sound a bit presumptuous. Yet, it was not just our assessment that the broad success statements out of the European Sovereign Debt Crisis were a bit overblown. The record of these attempts by Europe to “declare victory and go home” since last Spring is that the full details of what’s been agreed is often “much less than meets the eye”. And so it is proving in this case on several fronts. Not the least of which are the dislocations to the entire process by the seemingly misguided Greek Prime Minister’s desire to hold a referendum on things that were already ostensibly decided. It seems that Papandreou can Mr. Berlusconi in Italy are playing to their domestic political base in ways that might be very troubling for not just Europe, but the global economy.
That is not to say there is not any good news out there. In fact, the only reason the European rescue compromises could possibly have propelled the US equities to a significant new near term rally high is that some other news was also (at least temporarily) improved. That includes the preliminary US Q3 Gross Domestic Product pushing back up to 2.5% after the very weak Q2 figures. There is also this morning’s unexpected European Central Bank 25 basis point rate cut to 1.25%. That provides about as constructive an influences as anyone can imagine, pending the credibility of Mr. Draghi’s performance in a little while at his first press conference as President of the ECB. With the equities already benefitting from economic data reversing from the dismal US ‘double dip’ risk on the previous economic releases, the December S&P 500 future push back up to key 1,246-50 resistance (with a buffer to 1,260-65) appears fairly critical.
And it may well be the case that the improved US economic activity will buffer what is becoming a weaker picture for Europe. And if not, the Fed is putting out hints once again that it is ready to engage in another liquidity injection operation; even if it can specifically designate it as clear quantitative easing (QE3.) However, in general the economic news has been weaker than expected this week once again, and that’s not good. Everything from Australian housing figures through to most of the Purchasing Managers Indices have been weaker than expected.
So, even beyond the additional problems with the Euro-zone Debt Crisis rescue package specifics and the Greek Prime Minister’s stubborn adherence to the idea there should be a referendum on Greek agreement with the deal, there is plenty else for the equities (and other markets) to be concerned about. It goes back to the basic question we have been posing for months now, does crisis mitigation amount to restoration of robust global growth? We remain very skeptical of that on broader cyclical considerations.
All of which raises the question of why the equities took the European Debt Crisis rescue package so constructively in the first place? It seems to have been a happy coincidence that the rest of the background was temporarily so positive at the same time. Yet, in addition to all of the obvious issues on bank recapitalizations, leveraging EFSF (European Financial Stability Facility) up to the desired €1.0 trillion ($1.4 billion), and the nature of the new collateral provided Greek bondholders accepting a 50% loss on their current bonds, there is another pernicious aspect going forward from a victory the European powers-that-be will ultimately find very Pyrrhic. Another part of the bitter filling beneath the alleged headline success’ candy coating.
That would be the ultimate self-defeating ostensible success of the European powers-that-be from the vilification and ultimate disruption of the European sovereign debt CDS (credit default swaps) market. Just in case anyone is less than familiar with this, it is basically a form of insurance. The ‘swaps‘ are agreements to where the seller agrees to provide reimbursement of any funds lost if a bond should ‘default’.
And while that may seem to be a rather simple indication that significant losses will be restored, in the debt swaps markets the designation of whether a ‘default’ has technically occurred is not quite that simple. It is governed by the International Swaps and Derivatives Association (ISDA.) And under some pressure from governments and European public opinion that is negative toward the CDS market, the recent 50% agreed downgrade of the value of Greek government (i.e. sovereign) bonds was not deemed a ‘default’ because it was ‘voluntary’.
All (or almost all, and certainly the most important) of the bondholders are in the process of negotiating the agreed writedown. So it was not technically a default. Wild, huh? For any non-financial industry readers it should be clarified that the folks who deal in Greek CDS knew that the market was subject to these sorts of perverse technical situations brought on by European governments’ preference; or should we say extreme animosity toward the CDS market. Some further clarification for those who are interested in why this is technically still legal is available in recent ISDA press releases from last Thursday’s Updated Greek Sovereign Debt Q&A and Monday’s Statement on CDS Credit Event Process.
Why are these governments so negative on the CDS market? Quite simply they view it as a way to take out a bet against individual countries and Europe as a whole being able to service their debts. They saw what it did to both mainstream companies and especially the weak sisters of the financial services industry (Bear Stearns, Lehman Brothers, etc.) once the negative sentiment developed any serious momentum. And they want no part of having to defend Europe that has both very high public and private debt and an outsized banking sector (three times the size of total annual European Gross Domestic Product) against a CDS-driven speculative attack.
And possibly there is something to be said for that. Unfortunately, sovereign debt CDS can also serve a very useful purpose. When it is triggered by any reasonably good-sized writedown of the value of the securities (‘voluntary’ or not), it acts as insurance against the weakness of the underlying bonds. If that insurance function can be abrogated by government influence on the rating agencies or other official bodies (such as ISDA), then there is no way to hedge against losses in those instruments.
And that may be the crucial difference on which the worm turns in the next round of the Euro-zone Sovereign Debt Crisis. It seems even credit rating agencies have accepted for now that as long as most bond holders play along, it will not be a ‘credit event’ that would trigger a payout on the CDS. However, there are still likely no small number of Greek debt holders who only paid as much as they did because they felt any loss could be insured against in the CDS market. They are undoubtedly disappointed that the CDS is not paying out on such significant loss of value in the underlying bonds. As such, at least some of them are likely adding to the upward pressure on Greek yields (the counterpart to bond values falling) at present. They are washing their hands of the entire affair and liquidating both the long bond positions and CDS that has made them at least some money as its price has pushed up over recent months.
[Also likely is that no small number of sophisticated bondholders ‘gamed’ the market by purchasing more CDS than the face value of the underlying Greek bonds which they held. That has allowed them to reap enough reward from those positions to indeed substantially offset losses on their Greek sovereign debt holdings. Yet it must also be allowed that this is more of a speculation that anything resembling a classical insurance policy against the loss of value in those bonds.]
However, all of this fixation on the Greek debt situation that is already admittedly far gone might be misguided. As it relates to the general lack of confidence in the European sovereign CDS market, the bigger question becomes whether anybody believes there is a way to hedge that debt at such a crucial time? Without being too alarmist about it, this has implications for the future of the entire peripheral European sovereign debt situation. It will be very interesting to see what happens to the yields on especially Italian and Spanish debt if there is no confidence that buyers have any credible instrument to insure against losses.
It would seem that the only backstop that purchasers can reasonably rely upon is the hope that between the EFSF and the European Central Bank there is enough purchasing power to defend those bond markets. The fact that Italian bond yields went from 5.96% a month ago to 6.06% at their auction on Friday in spite of the ECB intervention is not propitious. While some of it is believed to have been liquidation of positions by the ill-fated MF Global, early this week those yields pushed up to near an all-time euro-era high of 6.40%.
And pending what Mr. Papandreou decides to do under pressure from almost everybody (both in and outside of Greece) to cancel his plan for is that early December referendum on accepting the European austerity plan, there will be quite a bit of additional risk. Of course, that is only in addition to the risks inherent in both the less than well articulated aspects of the European Sovereign Debt rescue plan, and the fact that the US fiscal reform effort is coming back under scrutiny due to the deadline for action by the Congressional Debt Reform Super Committee.
Interesting that everyone is conveniently ignoring the fact that the Thanksgiving deadline for legislation is hardly the real critical horizon. As we have been noting for some time, and as Director Douglas Elmendorf reminded Congress last week, the respected Congressional Budget Office needed those figures several weeks in advance of the legislative deadline; which essentially meant a couple of days ago. All of which adds to the fraught situation for the equities.
General Market Observations
Even if the December S&P 500 future manages to rally back up for a retest of the various mid-1,200 area resistances, unless it is back above 1,260-65 again sometime soon it will likely indicate weakness returning to all of the equities. Of course that will also mean that the government bond markets and the US dollar will hold supports that they are edging back toward as the equities have stabilized and rebounded since the Monday-Tuesday debacle. We suspect that December T-note future can probably hold the mid-low 129-00 area if equities do indeed stall on the current rally. Otherwise look for them to sink back below 129-00 once again. Similarly for the US Dollar Index, it is only eased back into its significant .7600-80 area so far, and the equities decision will be critical for whether it continues to hold or slips back below that area.
EXTENDED TREND IMPLICATIONS
EQUITIES: As we noted in Tuesday’s TrendView BRIEF UPDATE (http://bit.ly/v9KAHP), December S&P 500 future Rambo-ing above both 1,246-50 and more important 1,260-65 range (combined major Head & Shoulders Top and weekly up channel DOWN Breaks) late last week felt like more of a rampant bear squeeze at the top of what was already a 180 point rally from the early October 1,068.50 low. And so it has proven to be the obvious case, at least up to this point. What is important to understand right now is that December S&P 500 future bouncing back to the 1,246-50 area but no better than 1,260-65 is likely a failure swing in the equities that keeps the reinstated major DOWN signals from back in early August intact. That said, it also held on a dip below the obvious 1,230 area on Tuesday, and held right down into the low end of the far more critical support in the 1,215-10 area. And so the battle lines for all the equities, and indeed influence on the other asset classes, are now clearly articulated.
GOVVIES: Opposed to the weakness of the US Dollar Index well back below its important .7680-.7600 area support (which it is also back above and looking friendly), the govvies were holding up very nicely with only minor trading slippage below the support at recent trading lows at the end of last week. These were not just nominal trading lows, as the weakness below them should have signaled some fairly major DOWN Breaks, including December T-note future below its recent mid 127-00 low, December Bund future below its recent trading low at 132.94 (even if only marginally on trading Friday), and December Gilt future (that has been weak sister again of late) trading well below its 126.29-126.39 respective August and October trading lows. That should have represented a DOWN Break from a fairly major Head & Shoulders Top, yet which it could not even maintain for the daily Close Friday. That last one was also a very distorted form of that particular topping pattern, which is often a sign it is in fact a ‘false’ top.
What we see now is that the govvies are all back through significant resistances that turn them bullish once again. That includes December T-note future above 129-08, December Bund future above 136.00 which points to a push above its 139.19 high, and December Gilt future above 129.00 that points above 132.00. All of those areas now represent support. Yet the greater decision on whether they will indeed hold and what levels might need to be used for risk management purposes will likely be determined by wherever the govvies slipped down to on any failed December S&P 500 future test of the 1,246-50 and 1260-65 ranges.
FOREIGN EXCHANGE: the obvious strength of the US Dollar Index back above .7600-80 has been a perfect complement to the sharp weakness of the euro back below EUR/USD 1.3900-1.3837 low-end support after temporarily violating higher 1.4000-1.4100 serial resistances. While that all looked like a reversal of the previous US dollar up trend, in fact is each case the extremes that were seen on the recent reaction were unexpectedly sharp tests of the overall trend channel resistance for the euro up that EUR/USD 1.4250, and US dollar index toward down into the .7500 area. However, it is now obvious that for the near-term trend management it will be necessary for the equities to fail at no better than the December S&P 500 future test of the 1,246-50 and 1260-65 ranges if the near-term technical levels in foreign exchange are to hold.
The same goes for the recently very buoyant commodity currencies, as the previous critical Australian dollar activity in the AUD/USD 1.03-1.02 area is now reinforced by the Aussie having Broken UP from 1.0300 on its recent push up. After such a violent sideways churn since roughly back in April, weekly MA-9 and MA-13 are also right in the 1.03-1.02 area with both daily and weekly MACD back in balance. Whichever way it heads from here is more than likely a decisive indication, and also likely to be dictated by the equities due to that having been the overall case since May of this year.
All of the other currency relationships are also likely to be dominated by the equities trend decision, including the path for the recently intervention-weakened Japanese yen that is likely to still hold its haven status if equities are headed down in spite of the sincere desires of the Ministry of Finance. In fact, that will now be likely more so the case if the US dollar is impugned to any degree by a lack of success on the part of the US Congressional Super Committee. Which is why in general we are more partial to the govvies as a bullish vehicle than the US dollar even if the equities come under significant additional pressure.
Thanks for your interest.