Sage Weekly Letter – 6/10/2012

Spain is saved now and the eurozone is well on its way to a full fiscal-union…..right? Well, sorry to break the bad news….not quite. It seems that Spain has managed to successfully hold Europe hostage and has in return received the best bailout terms it could have hoped for, albeit for an amount wholly insufficient to solve its problems. As is typical of EU/eurozone agreements it appears that this weekend’s 100 billion euro bailout for Spain’s banks is an agreement in ‘principle’ – in fact, Spain has yet to make a “formal loan request” which is expected to come sometime before the June 21st meeting of eurozone finance ministers.

What we do know is that a framework for providing 100 billion euros to Spain’s FROB bank fund from the EFSF/ESM (ESM is still awaiting ratification) has been agreed upon. It seems that this is another clever way of obtaining ECB financing while making it appear to be something different. Bear with me as I attempt to explain the process which is likely about to take place: The EFSF, a fund that is still not properly funded and of which at least seven of its guarantor countries would have trouble coming up with bus fare, will provide Spain’s FROB with notes which the ECB is fully prepared to accept as collateral for euros which the Spanish banks so desperately need. Got that? Let me try it again – In return for a promise from Spain to repay the loan the EFSF issues notes to FROB, these notes then magically turn into euros when presented to the ECB, FROB then takes the euros and pumps them into Spain’s insolvent banks in return for bank equity stakes.

Based upon early reports from three weeks ago Spain was initially pushing the ECB to allow it to directly inject Spanish sovereign bonds into its banks in return for equity stakes – the banks could then swap the sovereign bonds for euros at the ECB window. Numerous reports came out stating that the ECB rejected this proposal outright as it would amount to monetizing the sovereign debt, something which the ECB is supposedly forbidden to do.

So what is the difference between the early Spanish plan and this weekend’s agreement to do the recap through the EFSF? The EFSF/ESM loans automatically move to the front of the line in Spain’s sovereign debt structure. Moreover, instead of Spain owing the ECB Spain now owes all the other eurozone member states – this is effectively another uncomfortable and forced step toward fiscal union. However, Spain is the big winner in this loan deal:

  • Spain surrendered NO sovereignty
  • There is no IMF involvement other than a minor supervisory reporting role with no enforcement power whatsoever
  • There was no austerity or deficit reduction pledge tied to the loan deal

At the end of the day Spain gets the ECB’s cash and simply piles more debt on top of its already ballooning pile of sovereign debt. Over the coming weeks we should fully expect to hear of conflicts over the details of the loan agreement and heavy pushback from the already bailed out eurozone members Greece, Ireland, and Portugal to retroactively receive the same sweetheart deal that Spain is receiving (the complaining already started less than two hours after Rajoy’s press conference).

Over the weekend John Mauldin wrote an excellent piece in which he called Greece a “dysfunctional state”, I will go one step further and call the eurozone (and the European Union as a whole) a dysfunctional family – they know they need each other but they are each always pushing for their own individual state interests rather than for the collective good of the family. As I have written many times the euro has always been about convenience, as long as it has provided many more benefits than drawbacks it was applauded and widely welcomed. However, the salad days are over and the painful adjustment process is at hand – I fully expect the dysfunctional family to do anything and everything to make the common currency work, it is just that the enormity of the task is likely to be too much in the end.

Before I delve into the current market structure I would be remiss if I did not mention China and John Hempton’s brilliant piece on the Chinese Kleptocracy:

“China is a mafia state – and Bo Xilai is just a recent public manifestation. If you want a good guide to the Chinese kleptocracy – including the crimes of Bo Xilai well before they made the international press look at this speech by John Garnaut to the US China Institute.

The Chinese establishment has a vested interest in getting the inflation rate up in China. Because if they don’t all hell will break loose…….Unless the Chinese can get the inflation rate up expect a revolution.” Hempton

Blog posts like Hempton’s are what make the financial blogosphere so wonderful. Here’s a real money manager who tied together several complex macroeconomic ideas, intelligence, and trends in a well written piece and shared it freely with the world – truly special!

China has been increasingly weighing on the market’s mind and last week’s rate cut by the PBOC coming just a few weeks after another lowering of bank RRR clearly confirms that China is in the middle of an easing cycle. In China you have powerful conflicting forces of a debt deleveraging resulting from a property bubble versus policy easing and central planners with enormous resources and will to engineer a ‘soft landing’ (I hate that term). What will be the outcome? Nobody knows but if the stock market is any indication last week’s break to the downside from a multi-month symmetrical triangle in the Shanghai Composite ($SSEC) is not a good sign:



Market Structure

Last week something interesting happened: On Wednesday the ECB appeared to deliver nothing for the market to savor yet equities staged a huge rally in the hours following Draghi’s uneventful press conference. What gives? It seems that the market once again proved its wisdom in anticipating this weekend’s Spain bailout which in all likelihood takes many of the worst case scenarios off the table for the foreseeable future. Last week’s market price action laid on top of a less than impressive macro backdrop is just another reminder to market participants to check their opinions at the door and that Mr. Market can do anything he likes.

The S&P 500 found support near its 200-day moving average and posted an impressive rally to end the week – should equities choose to display some exuberance following the Spain bailout news there is considerable resistance & price memory between $SPX 1340-1370:

Click to enlarge

Last weekend the crowd was fearful and bearish as the Russell 2000 was submerged below its 200-day moving average and appeared to have cleanly broken support. After last week’s impressive equity market rally and the weekend news flow the Russell may be in the process of ‘overshooting’ to the upside:

The most interesting research report I read over the weekend was Morgan Stanley’s FX Pulse which made a compelling, albeit long-winded, case for a massive private sector US dollar short position to the tune of $2 trillion – the two charts below tell much of the story (source: Morgan Stanley):

Essentially the case is that throughout emerging markets USD is the primary funding currency; therefore, in the event of a major unwind (a la 2008) there will effectively be a dollar short squeeze created as investors request that their emerging market investments be liquidated and dollars returned to them. So while sentiment is very bullish on the dollar and bearish on the aussie, euro, etc. and futures market speculators have made their largest ever bearish bet on the euro, this is a pittance in comparison to the global private sector USD short position.

The US Dollar Index ($DX_F $UUP) pulled back to its 20-day exponential moving average which is where strong uptrends often find support:

Finally, did anyone notice $WMT last week?

The current WMT rally is reminiscent of the 2007-2008 pre-Lehman rally in WMT:

My base case continues to be for a “whipsaw range” in equities over the coming months with a primary S&P 500 range of 1250-1370 and if I had to choose one quote to sum up my current market outlook it would be “Our greatest hopes and our worst fears are seldom realized.”

Last Week’s Best Idea

$TLT July bear call spreads using the premium intake to finance put purchases – this is an excellent method to define risk while expressing a view (calling a top :) ) that the treasury rally has gotten overheated and could correct sharply lower over the next 6-7 weeks.

TLT fell hard last week from its exceptionally overbought condition of the prior week. I am likely to take profits on the TLT puts into a gap lower on Monday while maintaining the July bear call spread.

Best Ideas

  • Long $USDCAD
  • Short $AUDUSD above parity using the 200-day SMA as your stop – wide stop because it is an unlevered/low leverage swing trade
  • $SPY july bear call spreads on a rally above $SPX 1340

The information in this blog post represents my own opinions and does not contain a recommendation for any particular security or investment. I or my affiliates may hold positions or other interests in securities mentioned in the Blog, please see my Disclaimer page for my full disclaimer.

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