Friday, August 5, 2011

Todays Rally-Crash-Rally-Unchanged brought to you by THIS GUY

Yet another fascinating day in the markets.

So, this morning before the bell we got the employment report. The economy created 114,000, of which 154,000 were private sector jobs (the government net fired people.) This allowed the unemployment rate to tick down a point to 9.1%. Not a great report but it did beat expectations and, given the massive crush of selling into the close yesterday the market opened with a very healthy pop. Immediately after the open the S&P was up 17 points or about a percent and a half. This was as high as it was to go however as investors quickly remembered that employment is a backwards looking number while the other negative data from the week, ISM manufacturing and non-manufacturing were forward looking and very weak. Also, there was no news out of Europe and though the European credit spreads were easing a little, taking the pressure off the troubled governments on the Southern rim, there was still no policy news that would put the market at ease. Add to this that there is still a lot of doubt as to whether the US will maintain its AAA rating and investors decided to take advantage of the employment bounce to get out while the getting was good.

In the first 20 minutes of trading the S&P dropped 30 points or just over 2%, a small move compared to the disaster of yesterday but a large move on any other day. The market then alternately drifted or plunged lower until about 12 noon New York time, at which time it bottomed at 1169. Treasuries which opened lower after yesterdays spectacular rally also traded up almost immediately after the open. Keep in mind that when Treasuries trade higher, they imply lower interest rates. Gold also spiked up about $20 as investors continue to fear all sovereign risk and consider gold the last best safe haven.

Then, a little before noon New York time, a bit of news came out of Europe. As I mentioned in my post of yesterday when Silvio Berlusconi gave a speech Wednesday night he announced no new policy measures. Then the markets crashed. After the bell in Europe Friday, Italy reversed this policy. The Wall Street Journal reported that Italy and the ECB were in negotiations the result of which was that the Italians would agree to a broader package of reform and to speed up their fiscal consolidation. In return the ECB might add Italy to its bond buying program. As mentioned, one of the things that Trichet had left out of his comments on Thursday was any indication that the ECB would intervene in the Italian Bond markets. Now it seems as though the ECB may help break the speculative attack on Italy and Berlusconi will use his parliamentary majority to push through reforms that would go a long way toward cleaning up the fiscal issues that enabled the attack in the first place. Among these, no doubt to the delight of the Tea Party, was a balanced budget amendment to the Italian constitution.

As an aside, I wrote a post a year ago about how I would thwart the speculative attacks in Europe, and a helpful primer on the role of CDS in launching speculative attacks if you are interested.

The markets loved this news and rallied stocks from 1168 to 1210 in about 45 minutes, the markets went straight up the whole time. Once they had gotten back to roughly flat on the day however the markets could not make any additional headway. They bounced up and down around the closing level of yesterday to finish just about where they left off yesterday with the S&P 500 at 1200. All in all it was a truly amazing day, it's not very often that you have the S&P 500 move up and down 5% in a day to close unchanged. So what does it all mean?

Well, I think it means a lot of things. For one thing it means that there is a HUGE amount of uncertainty in the markets right now. A few years ago the S&P would move 6% in a year, now its moving that in a day, day after day. To be fair there are a lot of things which the markets should be concerned about. If the world economy tips back into recession, the debt laden Western countries will struggle to use fiscal stimulus to attempt to jump start the economy. Exogenous shocks and previous monetary easing have raised inflation expectations to the point where further monetary stimulus is not likely to be forthcoming. Despite all the kings horses and all the kings men trying to put the European fiscal balance back together there remains a very real possibility of a successful speculative attack on the Eurozone which would then be transmitted into the European banking system, from the European banking system into the real European economy, and from there to the rest of the world. Such a disaster would be on a scale no one has seen before so no one really knows what to expect.

So what should you expect? Here's what I think will play out. I think the speculative attack on Italy will fail, I think the new package for Greece will hold so I do not think the Eurozone armageddon event will occur. The trouble is that the markets will take quite a lot of convincing and its not the kind of thing that can happen over night. Italy can default in a day, it cannot prove that it will never default in a day, it has to do that by not defaulting over a long enough period of time that people get used to the idea that it will not default. Another complicated aspect of this is that there are likely to be a lot of fractious arguments among the European governments about how to move forward, as with the debt ceiling debate in the US, these arguments have the capacity to unsettle the markets. So I would expect the European concerns to gradually fade out over time but punctuated with episodes of panic like the one we have had this week.

I think the US economy will get stronger in the second half and but I think the markets will respond unusually to the news as it comes out. The only thing the markets love more than real growth in the economy is a sign that the Fed may embark on another round of Quantitive Easing. So you might see markets paradoxically rally on news that the economy is weak, and more specifically, that inflation is in check in the expectation that this will encourage the Fed to print more money and thus raise all asset prices. I think it is also possible that, now that Congress has some time to work, that there might actually be meaningful progress on the fiscal front here in the US. I don't think that is the most likely outcome but I think they'll be talking with the rating agencies about what the minimum they need to do to keep the AAA rating and they'll do that. If the ratings agencies confirm the US AAA then it should be off to the races for risk assets again. If not, look out below.


Anonymous said...

Do you suppose that this is a feint by speculators hoping to engage the EFSF on its Italian front while planning to strike hard at it's weak Spanish flank?

Ken said...

No, I don't think it's coordinated quite like that. Remember that the speculators are all tiny compared with the sovereigns and central banks involved. They are also engaged in a relentless competition with each other for returns and for investor funds so not only do they not coordinate but they are generally highly secretive. They have the power to be stronger than the Central Banks and sovereigns aligned against them but only in aggregate.

The Italian bank trade is attractive because it has the advantage of striking at a country which is too big to fail and too big to bail out but will also pay off if any of the other peripheral countries default and send shockwaves into the European banking system.