Please, click here to read this article in pdf format: july-22-2010

The action in the past 48 hours has been horrible, to say the least. We went from a strong close in stocks on Tuesday to a loss yesterday, amid Bernanke’s speech, before the US Senate’s Banking Committee. We acknowledge the S&P500 has made a higher intraday low, closing at 1,069.59pts, but we still need to see higher highs sooner than later, to believe in a possible rally.

Volatility is thus the winner here, as confusion reigns. To us, very little makes sense these days. We think we have a clear long-term picture of this global crisis, but first we need to survive the present, to be able to enjoy the future.

There are two main macro “themes” this week: 1) US weakness and 2) Stress tests on Euro zone banks.
To discuss the first theme, we will do something very unusual in us: We will discuss Bernanke’s testimony today, before the Senate Banking Committee. We really hate to watch these speeches but our intuition told us everyone would be watching it too. Why? Nobody has a clue (we think) about where things are heading to. However, as the chart below shows (source: Bloomberg), the S&P500 is in a clear downward trend, making lower highs and lower lows. Until we can see a higher high, we will not be ready to accept a change here. The pink and green lines are the 100-day and 200-day moving averages, respectively:

It is clear that since mid May, on the peak of the Euro zone troubles, these averages have been broken. So, what does Bernanke have to do with all this? Everyone had been expecting some insinuation of the possibility of additional monetary stimulus under this stagnation. But Bernanke, predictably, just limited himself to say that the Fed has the firepower to use, when needed. That was the right thing to say. Why? Because as Bob Janjuah (RBS) in his early June commentary suggested, the Fed has very little ammunition to shoot. All they can do to lift asset prices is to engage again in securities purchases, just like we showed in our first graph, on our first letter, on April 14, 2009, when the Fed was carrying out its $300BN monetization of US debt (www.sibileau.com/martin/2009/04/14 ). If this is the case, Bernanke really has to see asset prices fall significantly more, say an S&P500 around an 850pts level, to ensure its medicine will be felt. Bernanke was bearish on purpose today, and fortunately took the opportunity to remind that room full of ignorance that the US deficit is “becoming” unsustainable. We feel Bernanke would have wanted to be more bearish in his comments, to accelerate the march towards the 850pts level, but with the tension between the Senate and the Fed, which has now gained more power under the new finance bill signed today by Mr. Obama, Bernanke risks being accused of not supporting the job creation efforts. He went even as far as to remind the Committee of the importance of the Fed’s independence. How will the USD behave in a downward path, vs. the Euro or other currencies? Will gold be able to remain above its 100-day average? Gold closed today at 1,185.10, while the 100-day average now is at 1,180/oz.

We think the CAD is the obvious candidate to suffer here, while on the Euro, things are not so clear, which is what brings us to our second point today.

As we wrote before, we consider the stress tests of the Euro zone banks simply irrelevant. They are misleading and totally miss the core of the Euro problem. Banks will be tested against their holdings of sovereign debt. But the value of that debt depends on its supply and demand dynamics. In terms of demand, let’s just say that some banks, as in the case of Greece, were forced to buy the debt. Supply will be a function of the financing needs of the Euro sovereigns. If fiscal deficits disappoint in at least one country, the contagion will spread all over the Euro zone again, because of its institutional nature, which is fragmented and lacks a unified bond market. Unity will have to be addressed (again) at the last level, the European Central Bank, affecting the value of the Euro once more. Therefore, running an inventory on sovereign bonds is ridiculous. It’s like checking how wet you are and how much wetter you can get while you’re under heavy rain.

When the US ran the tests on US banks, the inventory was on mortgages. The underlying source of the mortgages were houses and housing starts dropped dramatically, from the 2.2 million/yr to yesterday’s 549 thousand data release. And while bonds are sold from governments to banks and banks to the ECB in Europe, mortgages were bought from banks by the US government. The difference in approach is abysmal!

In summary, we would not be surprised if these stress tests tell us nothing new, and it would make sense too that the Euro retake its downward trend after the news, with a sell-off. However, as we pointed out on Tuesday, the situation in the US may mitigate the Euro’s trend.

Lastly and returning to Bernanke’s situation, we think it is a difficult one. When securities purchases began in March 2009, spreads were wide both in corporate and agency debt. If Bernanke retook such purchases towards the end of 2010, he will find much tighter levels. Unlike then, the monetary expansion would hurt credit more, we think, on renewed inflation expectations. Would the new money spill over onto stocks as an alternative? Or should it buy gold? What if a US state or municipal issuer suffers a liquidity crisis? Will these events occur before or after the November elections? There are way too many variables in this landscape. Volatility is the natural outcome.

Martin Sibileau