2011/11/09: Quick Post: Opera Berlusconi Continues… With Equities in Thrall, Yet Not Necessarily Bad

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Opera Berlusconi has finally seen the fall of the ebullient Prime Minister. If not for his policies and management of the state, he will at least be remembered for the excitement he provided. Of course, that includes the degree to which his shenanigans pointed out the ineffectiveness of leadership in the profligate southern European sisters, and even Europe as a whole.

It was the sort of demonstration of narrow partisan domestic focus that ultimately belied the myth of there being a cohesive Euro-zone even more so than the riots in the streets in Greece. Italy is just that much larger, ostensibly competitive on an industrial basis, and potentially capable of the right sort of fiscal balance if only the political will were effectively exerted. And yet, the other aspect which is clear even from Italian domestic politics is that it also suffers from its own North/South divide. In that sense, it is the fractal miniature example of why Europe cannot really be a monetary union without becoming a fiscal and political one as well; and that’s not happening.

As just a brief early word on two primary asset classes’ price activity, on current form it seems the government bond markets had it right by rallying on the weak economic news and disturbing developments in Europe. That was in spite of the strength of equities, which can be an anticipatory bid during earnings season and then weaken once things revert to normal. However, in this case they seem to have also been defying the crushing logic of the fact that Europeans who had been so adept at kicking the can down the road, well, finally seem to be running out of road.

Italian 10-year government bond yields shooting up above 7.00% in spite of Mr. Berlusconi’s resignation (at least seemingly so for now) came as somewhat of a surprise to casual observers. We are not sure why they would be so shocked by that, as an spite of his obvious weaknesses and problems Mr. Berlusconi was at least a strong leader up until the recent extreme loss of confidence in him. What we do know is that the market is exhibiting a rational reaction to the fact that no one else in Italy is considered much better, or much more likely to generate support for the necessary budget adjustments.

This would seem to be a classic example of “be careful what you wish for.”

There seems to have been a lot of that in the world of late, and this is one more example of a distasteful regime giving way to devolution into more disorder. And that happens to be very bad for a Europe that has failed to act timely to shore up the of effectiveness of its primary defense against financial market disorder: the European Financial Stability Facility (EFSF.)

While allowing along the way that the weakening global economic tendencies that are most pronounced now in Europe were going to make it tougher to stabilize indebted governments fiscal picture, Europeans engaged in nothing more than a significant exercise in partisan bickering and stalling. And the result is that the reluctant European Central Bank (ECB) and International Monetary Fund (IMF) are not inclined to step in to support the damaged Italian bond market to prevent yields from escalating further.

The problem is the (undoubtedly somewhat rightful) perception that at much above 7.00% Italian bond yields enter a zone where there isn’t much chance that Italy can balance its fiscal situation. Without much greater funding and agreement on the mechanism by which the EFSF can leverage its current funding, there isn’t enough money to support the Italian bond market. And that could lead to significant losses spreading through European banks, and possibly other countries’ banking systems. It now seems to be boiling down to whether the IMF can overcome its reluctance to step into the fray because of that risk to the broader global banking system.

The dilemma is that the US is the largest stockholder in the IMF, and any significant operations will require it to seek expanded funding. As we noted into and after the recent G20 meeting, what makes anyone think that Mr. Obama and sell the American people on the idea of coming up with a further major pile of cash to rescue Europeans who refuse to put up their own money to solve their problem… Again! …as many view this is the net effect of the previous major bank bailout, which was used to some degree to support various swaps that involved European banks.

General Market Observations

And yet, as bad as the equities look today, the December S&P 500 future is hanging around at no worse than 1,240 area, which is important on quite a few levels even if there is still a buffer below it back to 1,230. That is because 1,240 is the aggressive up channel from the major early October low from which the market has rebounded so substantially. It is also right around daily MA-18, and will be the arbiter of whether a recently struggling UP daily MACD rolls back over into a DOWN signal. This also correlates very well with DJIA slipping back down to its important 11,860-11,800 area, that includes similar technical tendencies.

So whether December S&P 500 future Closes back below 1,230 is likely the arbiter of whether the bears have finally regained control of the equity trend, or will be frustrated once again. In fact, the extended rally from that major 1068.50 early October low has been the story of a market that consistently failed to get back below the critical technical levels once it incrementally pushed above them.

Going all the way back to that first week in October, it would have needed to slip back below the low end of 1,155-45 at the end of that week to indicate a potential failure; and it did not. The same can be said for the serial higher technical areas that it held the low end of each on pullbacks once it pushed above them. Those were variously at 1,192-82, 1,215-10, and more recently 1,230, which it refused to remain below after the early week debacle last week. Now we will need to see if it can indeed slip back into the major lower August-October range. Even in so far as govvies and the US dollar have held up in spite of the recent strength of equities

EXTENDED TREND IMPLICATIONS

▪ Long-Dated Government Bonds: On current form, all of the govvies would have to drop back below violated resistances in order to signal any potential for sustained further weakness. And in the case of the December T-note future and the December Bund future, they failed to even get back down to that important lower congestion on last week’s selloff. That would be December T-note future and 129-08/-00, and December Bund future 136.00-135.80. On the other hand, the December Gilt future did indeed retest the top of its 128.80-.50 violated resistance last week, yet also remains well above it so far this week. The most important aspect of that violation of resistance in the December Bund and December Gilt future is that they represented the Negation in each case of Head & Shoulders Top patterns that had been forming since mid-August. And that’s pretty bullish, indicating the potential to move to a new high that will obviously be reinforced by any failure in the equities.

▪ Foreign Exchange: US Dollar Index strength 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 near-term trend management may make it necessary to temper any friendly sentiment toward the buck on two potential considerations.

If December S&P 500 future can indeed hold no worse than 1,230, it might well push out above 1,260-65 again in the near-term. The other concern is more so whether there is any significant refocus from Europe back to the likely failure of the US Congressional Fiscal Reform Super Committee. We suspect that likely outcome may well attract another US government debt rating downgrade from the credit rating agencies. As we have seen previous, however perverse it may seem that likely represents a bigger problem for the equities than the government bonds. However, as in that case any drop in the equities market will be linked directly to pernicious US developments, it is far more problematic whether the US dollar develops a haven bid.

Which is why we have been far more partial to the govvies than the greenback on our current bout of skepticism toward the equities. That also informs our view of why December Crude Oil future might react somewhat substantially back below the 95.00 resistance it only pushed up through earlier this week if equities fail, yet the December Gold future might remain strong. It seems that Gold and mainstream commodities have parted ways once again due to the disarray in the global financial market restoring a ‘haven’ bid to the yellow metal. Back above the old August 1,682-92 Runaway Gap and pushing above the 1,750 resistance with a gap above 1,771-75 clearly restores its haven bid. It seems it is once again beginning to reflect potential for central banks’ continued liquidity infusions (more on that in another post soon) to further dilute the value and credibility of fiat currencies. The interim resistance in the low 1,800 area could now easily be overrun on the way to the more prominent levels in the mid-1,800s.

Thanks for your interest.