Please, click here to read this article in pdf format: august-26-2010

In our last letter, we suggested that the tension in the markets was going to be released, to the upside or downside, by an unknown catalyst. That catalyst came the day after, on Tuesday, as the horrible home sales print came out.

But that is history and we would like to now focus on a few things that caught our attention. These are “hints” and the comments that will follow, out of these hints, will be mere inductive reasoning. In our view, deduction is far better than induction, for there is nothing more practical than a good theory. However, at this time of uncertainty, theories are not abundant and we have to look for whatever pieces of information the markets give us.

Given that we are neutral-to-bearish on credit and sovereign risk (yes, that includes the USA), we found it interesting that shortly after the home sales announcement on Tuesday, the 30 yr treasury sold off by approx. 1%. Indeed, it may be seen from the perspective of a flattening move, which is actually taking place since the Fed’s announcement last week. But in any case, the Tuesday’s move, smelled to a “sell with the news” move. Why? Because the bearish news out of the US only imply higher sovereign risk and we are already touching record lows in yields. This is also the reason why we turned neutral-to-bullish on gold on that same day.

The other interesting “hint” was the resistance in the Euro and the price of oil yesterday. Just when Morgan Stanley was issuing a research note titled “Ask not whether governments will default, but how“, that same house was also printing another one, informing of their decision to take profits on the Euro. We thought that was inconsistent at best. It’s true, there are signals that suggest Germany is enjoying a lower Euro, but strength in Germany alone is not going to help the monetary union. In fact, strength in Germany “alone” is what triggered weakness in the Euro, given the lack of a clear wealth transfer mechanism within the union. This shortfall is what creates the jurisdictional arbitrage, from peripherals to Germany and from Germany to Switzerland, for those really conservative. Below we show two charts (source: Bloomberg), which we have discussed before. The first one shows the gap in sovereign risk (5-yr credit default swaps) between Spain (a peripheral) and Germany. You can see we are back at crisis levels. The other chart shows the gap in liquidity costs between the Euro and USD currency zones. It is widening. Sure, it does not necessarily mean that these signals will lead us back to May/June levels. That would be pure induction from our part (hence the above disclaimer). But they also show that the current environment is not constructive either.
Therefore, how would you interpret the bounce in stocks and oil yesterday afternoon? So far, it looks like a mere bounce…

Martin Sibileau