Following up on the post from earlier this weekend about the Euro short squeeze/market short squeeze, I'll try to break this complicated matter down in to more understandable bits, but in effect, right now little matters in the short term EXCEPT what the Euro does.
There is a long standing legacy arbitrage that most HFT programs have programmed into their algorithms, that is the notion that a cheap dollar is good for US stocks, and why? Largely due to increased sales, especially for multi-national corporations-think Dow Components, many S&P and NASDAQ components as well. There's also perceived value or the stocks are cheap on a weak dollar. The same relationship exists for oil, but for different reasons. Crude is traded the world over in $US dollars. All things being equal with no production changes, a weaker dollar means less money for the oil producers, thus the cost of oil must rise to accomodate the weaker dollar. How does the Euro fit in? Simply, it represents (of all the currencies in the world) 50% of the Dollar Index, no other currency has as much influence over a dollar's value.
So what is so strange about recent trade when a short squeeze was expected anyway?
It's not the short squeeze, it's almost a closed feedback loop in the Euro that is resilient to everything that would normally push it down, not the least of which would include sovereign EU downgrades, EU banking Downgrades, widening costs of credit default swaps on both EU banks and sovereign nations, disagreement between the major players behind the EFSF, the US throwing away the idea of adding capital to the IMF to help the EU, fading hopes of a Chinese led EU bailout, invalid stress tests, banks admitting to withholding investments in the stress tests which will now cause them to lose book value, and more importantly, an interbank liquidity freeze in the EU, just like we saw in the US in 2008, when banks didn't know what their counter-party risk was, so they stopped all overnight lending. The "FAD" actually had to force the biggest banks to take Billions of dollars, even $25 billion for a single bank, to unfreeze the banking system.
In addition to a liquidity freeze in EU banks, EU banks have been told to raise their capital ratios. The banks are resisting for several reasons:
They are trading very cheap compared to book value so it makes no sense for them to try to raise money through offerings.
Here's a quote from the FT:
"“Why should we raise capital at these [depressed share price] levels?” said one eurozone bank boss. The average European bank’s equity is trading at only about 60 per cent of its book value."
Many are finding they are locked out of capital markets or the costs are too high.
"Banks and their advisers said their scope to raise fresh capital from investors was all but non-existent. “I don’t think anyone has access to the markets now,” said one senior European investment banker. Investors are loath to commit to fresh equity injections, in the knowledge that the new money would simply be soaked up by sovereign debt writedowns, bankers said."
So they have decided on a strategy of "Shrinkage" instead.
"However, the banks’ “shrinkage” strategy is likely to prove controversial with politicians and regulators if it led to bankers lending less money to customers, jeopardising the eurozone’s fragile recovery, analysts warned.
European companies rely on banks for as much as 80 per cent of their funding compared with only 30 per cent for US companies."
"Many banks believe they can reach the targets without resorting to government recapitalisation. In recent weeks, both BNP and SocGen have signalled plans to offload a combined €150bn of risk-weighted assets."
Any decrease in lending, through "Shrinkage" threatens the EU recovery as lending, without raising more capital then they lent, would not allow them to raise their capital ratios as they have been ordered to do. Liquidating risk assets not only raises cash, but also raises the Capital Ratios. The assets being liquidated are particularly in $US dollar denominated assets, which are largely tied up in 3 investment entities, 1) is stocks-they apparently aren't ready to liquidate stocks in to a short squeeze for obvious reasons or they may have started to. The other 2 main investments are synthetic investment vehicles which largely fall in to 2 categories: CMBS (Commercial Mortgage Backed Securities) and assets in PrimeX.
PrimeX is an index created by Markit which allows institutions to go long or short and thus have exposure to prime real estate loans, the good ones, unlike the subprime loans which were also offered by Markit.
Last week the PrimeX indicies were hit hard. They rarely if ever have traded below 100 (par) as you can see by the charts below, they are now being liquidated. These are considered "prime" or high quality loans in both fixed and ARM mortgages, there are 4 main indicies. Index 1 is of higher quality, remember these haven't dipped below 100 until now.
Fixed 1
Fixed 2
ARM 1
ARM 2
"Many of the indices have recently breached 100, or are veering dangerously close, having sharply plunged in the first week of October.
That begs the question of what is causing the decline."
They are seeing heavy selloffs and the capital is being repatriated back to the EU banks, which means dollars are being sold and Euros bought, thus sending the EUR/USD higher-just look at the dates of them being sold off in relation to the Euro rally.
Particularly at risk, as you may know because of the rating's agencies, are French Banks.
Something very odd happened this week to French 10 year Bunds which trade nearly in lockstep with German 10 year bunds, they sold off and hard.
"French 10-year government bonds dropped, pushing the yield up by 38 basis points, the most since the week ended Oct. 9, 1998. The decline pushed the difference in yield, or spread, between French and German bonds to the widest since the euro was introduced in 1999."
"
The reason?
"I assume the hit is coming from Fitch who said they are going to revise bank ratings and it was all the big French banks again," Marc Ostwald, strategist at Monument Securities in London.
Ten-year French government bond yields jumped 12.6 basis points to 3.10 percent, taking the gap between French and German 10-year yields to euro-era high of 94 basis points.
There's a very strong correlation between the Bunds and the Euro, here's a chart of what happened to the French 10-year vs. the Euro-
As you can see, right about the time we saw our first signals of distribution, which was assumed to be a market pullback from overbought levels-not a full on decline, the French 10-year fell out of all correlation with the EUR/USD and set new records. Usually a signal like this would signal a massive sell-off coming in the Euro. If you look close, you can see a positive divergence between in the Bund between Sept. 22 and Oct. 14th that sent the Euro higher. Whether the Euro continues to trade in it's own world or whether this massive divergence between the two plays out, remains to be seen. I tend to come down on the side of a reversion to the mean, which would suggest a massive fall in the Euro.
However, this hasn't happened this past week because of the repatriation of sold $USD denominated assets, back in to Euros-simple supply/demand-the $USD is being sold, the Euro bought so banks across Europe and particularly in France can raise their capital ratios.
From Deutsche Bank, who seems to have put this altogether:
"The latest French balance of payments data (http://www.banque-france.fr/gb/statistiques/economie/economie-balance/ec... ) again shows large French portfolio inflows that are very surprising.
In the past, we have noted that the periphery flows fleeing toward the core has tended to leave the EUR trading like a closed system to the outside world, which is one explanation for surprising EUR resilience"
This is the same phenomenon that happened after the Japanese tsunami, they needed to repatriate currency which drove demand up thus leading to yen strength, except in this case the algos are programed to see Euro strength as a buying opportunity in the US market.
Put another way, European banks (especially the French) are selling Dollar Assets to get Euro cash.
Having sold the Dollar assets, they need to sell the Dollars and buy Euros to meet Euro liabilities and in the process, the EUR/USD goes up, fooling the robots to buy stocks at the same time, exacerbating an already in place short squeeze.
This is why many technical indicators, perhaps all, in the short term are near useless-the Euro is trading as a closed system right now. Again, the question remains "Does this last?" I tend to again fall on the side of reversion to the mean and suspect some algos may have already been re-written or modified over the weekend as this has the potential to create an extreme risk scenario from a portfolio management perspective that these funds operate under.
Does this mean that charts and the information they give us are useless? No, they aren't useless, except in the very near term until there is a reversion to the mean. Keep in mind that the EU has massive problems that have now spread from the PIIGS to the core, France being an example. Being long the Euro at these levels and long risk assets has the potential for a cataclysmic reaction to the downside.
I think what happens in the market with distribution, which seems to be happening in to this strength, tells us something important about what is still happening in preparation for the reversal or regression to the mean.
Which probably means it's very important to watch what is happening to the Euro in both price and underlying action as well as the market and ES. Remember that what I tried to describe above is an extraordinary event, it is not something we have probably ever seen before due to extraordinary events in the Core of the EU, as well as relatively new Black-Box or HFT trading systems that are not run by humans, but computers. These operate in the market, but are very different then Managed Funds that liter Wall Street and the world.
Here's a few charts and I'll update as anything new becomes known...
To break the charts down, and they have the same features, we had a top in July with a strong daily negative divergence that led to the July/August sell-off, then a relative positive divergence leading to this consolidation pattern over the last 10 weeks, the positive divergence I mentioned last week for the October rally and a current negative relative divergence, again making the CCI chart pattern worthy of consideration as a possible model for the market. It would be interesting to study the CCI hart in context of the Japanese Tsunami, but that's for another day.
The current EUR/USD open, which of course is very early, is flat from Friday's close and below Friday's highs. As always though, a lot can happen over night in FX markets.
Maybe if I'm awake later, I'll check out the ES futures. So far Asia looks weak.
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