This is the calm before the storm. We have been in a news vacuum for the last month and the market has fallen into an extremely tight trading range. Long periods of consolidation tend to produce big breakouts.
Q2 GDP was released this morning and it barely moved the needle. Traders have squared up and they won’t be taking new positions ahead of major events next week. The action the rest of the week will be lackluster.
Jackson Hole had the potential to spark activity. The ECB President backed out and he is saving his announcements for next week. Ben Bernanke will speak Friday morning at 10 AM Eastern. I doubt his rhetoric will change much and he will not move the QE3 timetable forward. This would normally spark a little selling, but I don’t believe it will.
Bears are scared. With the market near multi-year highs they won’t get aggressive until Draghi speaks. He will speak at the European banking union early next week. Later in the week the ECB will release a statement and that is when we are likely to hear about future plans. The expectations are extremely high.
The ECB plans to keep short-term sovereign yields from rising. The EFSF will purchase bonds if the ECB is satisfied with fiscal spending cuts. This facility has become the buyer of last resort.
European banks borrowed money from the ECB via the LTRO. They did not use the proceeds to purchase sovereign debt and interest rates in Spain and Italy spiked. Consequently, the ECB had to come up with another plan. This lack of institutional demand is a red flag and the situation is dire.
The ECB is forging a plan for a centralized European banking system. Analysts want to see details in the next few weeks. Even if the plan is drafted, member nations might not want to relinquish control over national banks.
Historically, the ECB and EU have played catch-up and they rarely get ahead of the curve. The stakes are high and they had better deliver. If they don’t, Draghi’s speech will be a “sell the news” event.
China’s economy has been deteriorating and it is the growth engine of the world. Global iron ore producers state that the “boom” has ended. China will release its official PMI on Monday. The flash PMI was weaker than expected and the Finance Minister hinted that they were about to ease. China’s stock market is at multi-year lows and traders are wondering if the PBOC can stop the economic contraction.
Domestic releases will also dominate the scene. ISM manufacturing, ISM services, ADP employment and the Unemployment Report will be released during a compressed week of trading. The landscape will change dramatically and volatility will pick up.
This is a very dangerous trading set-up and we need clarity before we can take a stand.
If China’s PMI comes in weak and the PBOC cuts rates, the market could rally on the news. If the ECB remains committed and details are provided, the market will make new highs. The employment data next week should be in line and it won’t have a huge impact. Initial claims have been steady the last few weeks and I’m not expecting any surprises.
If China’s PMI comes in weak and they don’t ease, the market will pull back. Comments from the ECB will be scrutinized and if the details are sketchy, traders will grow impatient. Any deterioration on the jobs front would put pressure on the market. Given that Benanke won’t move up the timeline for QE3 during Friday’s speech, the market could decline swiftly.
The table is set for a move in either direction. With option implied volatilities near historic lows, I do like buying October VIX/VXX/VIXY calls. I would also suggest buying a few at the money SPY calls. If the market rallies, you won’t lose much on the VIX calls since option premiums are already near their lows. The SPY calls should offset those losses. If the market declines, option premiums will explode and the gains on the VIX calls will outweigh the losses on the SPY calls. This is a hedged way to play a market decline and I would use a 4:1 ratio.
Look for very quiet trading the rest of the week. We will see a small blip of activity Friday morning when the Fed Chairman speaks. Tuesday morning, markets will react to the PMI’s and I’m expecting a small pullback.
The two largest economies in the world (US and China) have diverging markets. One is at a four-year high and the other is at a four-year low. Volatility lies ahead and the trading environment will improve next week.
Things could get crazy; enjoy the last few days of this reprieve.