Deceptive Calm Continues
Italy finally has a new prime minister, Enrico Letta, who is expected to be supported both the center-left (its leader Bersani has recently resigned, as he was unable to get the bloc to vote for his choices for the job of president) and Berlusconi's center-right coalition. Apparently this has given fresh impetus to the buying of peripheral bonds in the euro area. Consequently, credit default swaps and other measures of systemic stress remain subdued. However, there are still technical divergences that must be considered worrisome and inflation expectations in Europe continue to plunge (this is often a precursor to credit stress). Moreover, safe haven debt continues to enjoy a good bid. We ask again, if everything is truly fine, then why is this so? Something obviously does not compute here.
EU Watchdogs Release 'Risk Assessment'
At the moment, the euro area remains quite calm. Although risks have actually increased due to continued economic weakness in both the 'core' and the 'periphery' (for instance, the depression in Greece continues with full force, with unemployment hitting a new record high at over 27% recently), the markets are still pretending that everything is fine. All it apparently takes is 'political will' and the mere threat that the ECB's printing press could swing into action.
Meanwhile, the EU's three 'financial watchdogs' have published a report of where they think the biggest risks currently are. As a rule of thumb though, the watched pot rarely boils – it is the things that are not receiving any attention that are most likely to go wrong. However, we would certainly agree that they do have a point regarding the banks.
Credit Market Charts
Up until recently the reaction to the developments in Cyprus has been quite muted, however, the warning signs are now getting more obvious. We have therefore decided to present an update of a selection of our usual suspect charts: CDS on various sovereign debtors and banks, bond yields, euro basis swaps and a few other charts. Charts and price scales are color coded (readers should keep the different price scales in mind when assessing 4-in-1 charts). Where necessary we have provided a legend for the color coding below the charts. Prices are as of Monday's close.
Tough Guy Becomes Whipping Boy
To say that Jeroen Dijsselbloem 'ruffled feathers' as Der Spiegel does here is an understatement. It would be more precise to state that he has provoked howls of outrage and disbelief all around. Der Spiegel berates him for not being diplomatic enough. Allegedly he was also 'too rude with the Cypriots' (meaning the negotiators). And – horror! – he lacks the 'gravitas' of his predecessor J.C. Juncker, the euro-group's former self-confessed liar-in-chief. Only now can we see what an irreplaceable super-human bureaucrat Juncker really was. Woe betide us now that he's gone!
Can the euro-group even continue with a ruffian such as J. Dijsselbloem heading it, even though he has merely a 'ceremonial post' as Der Speigel assures us?
PBoC Open Market Palpitations Continue
Here is the update of the PBoC's weekly open market operations from Thursday last week (as we have previously pointed out, there seem to be unusually large swings between monetary pumping and drains of late). The chart depicts the net of bill sales and purchases and repos/reverse repos. After the big draining operation of the previous week, another small drain resulted from last week's activities:
PBoC open market operations, net effect – click for better resolution.
It Goes Well With the Sentiment Picture …
Our friend PN has sent us his latest Elliott Wave update on the evolving near term pattern in the S&P 500, which happens to jibe with our observations about sentiment and positioning posted earlier.
S&P 500 Index, near term Elliott Wave pattern, by PN – click for better resolution.
Liquidity Trumps Everything – For Now
The stock market chugs ever higher, but there seems to be little to support this run-up from a fundamental standpoint. For instance, fourth quarter corporate earnings for the SPX are expected to grow by 1.9%. Only three months ago they were estimated to grow by 9.9%. A little over six months ago the estimate was for 13.7% earnings growth. Three regional Fed business surveys in a row have come in way below expectations and the NFIB small business confidence index has just hit a three year low.
The main reasons why stocks keep getting bid up are probably the growing conviction that the euro area crisis is over (more on this below) and the acceleration in US money supply growth from an already elevated level. Below is a chart of the consolidated asset side of the Fed's balance sheet:
Assets held by the Federal Reserve – the central bank's balance sheet has hit a new high – click for better resolution.
This is expected to grow by another $1 trillion over the course of this year. Given the wobbly state of the economy – three of four major coincident indicators have topped out last summer already and are in decline – it is a good bet that the 'QE4' program will indeed continue for the remainder of this year. From 2014 onward, the Bank of Japan intends to monetize US t-bills to the tune of 10 trillion yen per month according to its latest inflationary plan announced yesterday.
A Remark on Corrective Patterns
A little over a week ago our reader PN graciously provided us with an update of his Elliott-wave views on a number of markets. Unfortunately we only had a chance to catch up with e-mails very recently, so these are posted with a slight delay. However, in spite of the fact that the charts are now slightly dated, they remain relevant as a big picture overview, so we decided to present them anyway.
As a general remark, corrective waves are especially difficult to assess in real time. This is so because a very large number of corrective patterns exists and one can at best generalize regarding the type of pattern to be expected once a corrective wave begins to take shape.
This generalization is based on the 'rule of alternation': if the second wave was a sharp, then the fourth wave is going to be a flat and vice versa. In other words, the market has a strong tendency to alternate between different corrective patterns depending on their position in the wave of one larger degree. It is of course not known why this is so – it has merely been observed empirically.
Selected Credit Market and Other Charts
We haven't done a chart update in quite a while, mainly because nothing particularly interesting has happened in euro-land credit markets of late. However, below is an update of a small selection of our usual suspects in order to provide some orientation - i.e., to show where things stand at this juncture.
It is still not possible for us to ascertain definitively whether CDS on euro-land sovereigns have lost their signaling function with the ban on 'naked' trading. This will only become evident once the next wave of the crisis begins, something that could e.g. be triggered by one or more of the countries that are currently on the edge missing their deficit targets next year, or unexpected political complications (Italy's upcoming election could for example be a trigger for such).
How Important is China for Commodities Prices?
It is widely held that China's economic boom of the past several decades is the chief reason for the big rise in nominal commodity prices since about 2001 (depending on which commodity one picks, the boom began for some in 1998 already, for others as late as 2002). However, this view strikes us as too simplistic. In fact, while China's economic trends undoubtedly influence the demand for commodities, one would then have to ask: why did commodity prices fall in the 1980's and 1990's? Both decades have seen heady growth in China and elsewhere in Asia, albeit interrupted by occasional crises.
It is probably better to ascribe the boom to a few additional factors as well, one of which is probably the by far most important: monetary inflation. It is no coincidence that the boom got going when inflationary policy got into high gear.
In addition, the supply response to the 1970's boom required some time to be worked out of the market's system. After a long grueling bear market, investment in a lot of commodity production had turned into a trickle and given the ever larger lead times and capital intensity of commodity investment projects, it initially only revived sluggishly. When the time had come when it finally looked like commodities were a 'sure thing', they promptly crashed in 2008. Money printing has however not only continued since then, it has accelerated mightily.
A Little Market Tantrum …
The recent market swoon doesn't yet look like much on a daily or weekly chart. But it sure 'feels' qualitatively different from the last correction. It even feels different from the July-October 2011 decline, as the worrisome backdrop provided by the euro area debt crisis at the time is not present this time around, or rather only as something that is quietly simmering in the background, without any urgency.
The Stock Market Becomes Sneaky
What was notable about trading in the stock market on Thursday was the market's utter inability to muster a bounce after the big sell-off on Wednesday. There was a feeble attempt at a rebound in the first 20 minutes of trading, followed by a mild decline, then a sideways move in a tight range, another mild lurch lower, another feeble bounce attempt, more sideways trading…and then the day's losses more or less doubled in the final 20 minutes.
That is of course rarely a good sign. Most of the day actually felt rather boring, and when the small rebound from the mid day lows began to take shape, most observers probably thought that the market was about to come back after a small sell-off clearing out a few residual margin calls. The slide at the close was likely a nasty surprise, and although the overall price damage was much milder than on Wednesday, the psychological damage may actually have been greater.
Below is a two day, 5-minute chart of the DJIA illustrating the action:
The last two days in the DJIA, 5 minute candles – click for better resolution.
Credit Market Charts
Below is our customary update of credit market charts: CDS on various sovereign debtors and banks, bond yields, euro basis swaps and a few other charts. Charts and price scales are color coded (readers should keep the different price scales in mind when assessing 4-in-1 charts). Where necessary we have provided a legend for the color coding below the charts. Prices are as of Friday's close.
A Signal Loses Its Significance
As a friend recently reminded us, the charts of credit default swaps (CDS) on sovereign debt in the euro area that we are regularly updating in these pages may no longer be indicative of the underlying reality of market perceptions.
This is so because the EU's bureaucrats, in their ongoing attempts to manipulate markets, have issued a ban on so-called 'naked' trading in CDS. This means that speculators are no longer allowed to buy and sell CDS contracts to merely express their opinion. Unless one holds the underlying bonds, one will no longer be allowed to trade these credit instruments from November 1 onward.
Instead, trading in them now takes place only 'by appointment', as every trade must be sanctioned by the EU's bureaucrats. A buyer or seller of CDS must now be able to “prove that a CDS position is a hedge, showing correlations (both quantitative and qualitative)”.
Not surprisingly, liquidity in the CDS markets is evaporating as a result of these new regulations and we can probably no longer rely on these markets to give us relevant signals (we will however continue to keep an eye on them to see what develops).
5 year CDS on the sovereign debt of Portugal, Italy, Greece and Spain – with hedge funds no longer able to trade these instruments unless they hold the underlying bonds, liquidity in these markets is drying up and the quality of their price signals comes into doubt.
Credit Market Charts
Below is a selection of our customary update of credit market charts: CDS on various sovereign debtors and banks, bond yields, euro basis swaps, plus a few other charts. Charts and price scales are color coded (readers should keep the different price scales in mind when assessing 4-in-1 charts). Where necessary we have provided a legend for the color coding below the charts. Prices are as of Friday's close.