Yesterday, the market drifted higher on light volume and this morning we are making a new post crash high. This was not a news driven rally.
Angela Merkel said that she supports the ECB’s recent action. That should not come as a surprise since Europe’s tactic has been the same for the last two years. They are supporting short-term bond auctions to prevent a financial crisis.
The LTRO program infused the banking system with cash. Financial institutions were supposed to use the cash to purchase short-term sovereign debt. Unfortunately, they are up to their eyeballs in PIIGS debt and they did not sponsor sovereign bond auctions. Spain’s banks are tapped out and they can’t support their own auctions. Interest rates in Spain and Italy jumped and the ECB had to forge a new plan.
Now, the EFSF will be used to purchase sovereign debt. They are the buyer of last resort. Member nations (strong and weak) will have to fund the EFSF and resistance will grow as PIIGS continue to ask for handouts. The troika has demanded austerity programs from Greece/Portugal and Spain will lose some control over its fiscal spending. That is why Spain has not officially asked for help from the EFSF.
Now we know that no matter how much money is pumped into banks, they don’t want to use the proceeds to purchase sovereign debt. In this light, the developments in Europe look much different. The appetite for this debt is very low.
An aging population means that structural deficits will expand in coming years. If entitlement is not reformed, the problem will escalate.
The ECB’s Band-Aid worked and the bleeding has temporarily stopped. The plan will be widely accepted until member nations have to add funds to the EFSF.
Earnings have been good and the economic releases are light. There is nothing to stand in the way of this rally for at least a week.
The next big news comes out Thursday. Flash PMI’s will be released and China will be the focal point. If conditions are worse than expected, the damage will be contained. Traders will expect the PBOC to ease. The expectations for Europe are extremely low and any surprise favors the upside.
Central banks are backstopping the market. In light volume conditions, even a small bid will push the market higher. I expect us to break through major resistance in the next week.
This rally will hit resistance when economic conditions force central banks to fire their last bullets. Those actions won’t stimulate the economy and the selling pressure will build. If interest rates in Spain and Italy start to creep higher, the EFSF will be forced into action. These scenarios will take time to play out (perhaps a few weeks or more).
Financial institutions are buying short-term sovereign debt on the notion that the EFSF will be there to backstop them. Sovereigns will issue shorter-term maturities to reduce borrowing costs and all of the debt will have to be continually rolled over.
In the US, our average maturity is four years. With interest rates near historic lows and the ten-year trading below 2%, we should be refinancing all of our debt with long-term bonds. Unfortunately, if we started to do that, long-term yields would climb quickly. That maneuver would buy us time to figure out our structural debt problems.
As long as China’s economic activity doesn’t fall off of a cliff (I don’t believe it will) and as long as European credit concerns are contained, the market will grind higher.
The volume is extremely light (comparable to Christmas) and we have not seen these activity levels since 2007. That indicates a very low level of commitment. This week, option expiration provided upward pressure as we broke through resistance. Traders legged out of hedged positions yesterday and that “goosed” the market. This was not a huge factor, but we don’t need much of a catalyst during light volume sessions.
I am cautiously trading this rally and I don’t see any storm clouds in the next week. The PMI’s Thursday favor the upside. Yesterday’s economic releases were weak and the market shrugged off the news.
I’m trading stocks that have consolidated in a tight range for two months and are breaking through horizontal resistance. These patterns tend to produce sustained moves. Use the Live Update table as your guide. Keep your overnight exposure to a minimum and know that this is a very tenuous rally.