Market Sentiment

The opposition seen in Germany in response to Mr Draghi’s preparedness to buy sovereign debt implies that current posturing in Spain will not wear well with the politics of signing a Memorandum of Understanding in Germany. As Goldman notes, the more the Spanish administration indulges domestic political interests and is perceived to be taking undue advantage of external support, the more explicit conditionality is likely to be demanded. This would add to any existing tensions, given Spain’s opposition to conditionality. This is disappointing partly because it is avoidable if Spain were to accept the external support on the terms currently available. Spain will have the opportunity in the coming weeks and months to demonstrate that it wishes to avoid these incipient risks. But we, like Goldman, continue to believe that some of the incentives created by Mr Draghi's preparedness to act could prove difficult to resist- and will thus delay any real game-changer that is priced in.

Who in their right mind would buy any government bonds today?

What Draghi did is buy some time. About three months worth of time. But at what cost?

Every now and then we prefer to sit back and let some of the smartest money speak, especially when said smart money agrees with us. In this case, we hand the podium over to none other than Paul Singer's Elliott Management, which after starting with $1.3 million in 1977 was at $19.8 billion most recently. No expert networks, no high frequency trading, no "information arbitrage", no crony capitalism and pseudo monopolies of scale, and most certainly no bailouts: Singer did it all the old fashioned way: by picking undervalued assets and watching them appreciate. The timing is opportune because while Elliott has much to say about virtually everything in their latest 20 pages Q2 letter, it is the billionaire's sentiment vis-a-vis US Treasury debt that may be most critical, and may be the catalyst that resulted in today's abysmal 10 Year bond auction. To wit: "long-term government debt of the U.S., U.K., Europe and Japan probably will be the worst-performing asset class over the next ten to twenty years. We make this recommendation to our friends: if you own such debt, sell it now. You’ve had a great ride, don’t press your luck. From here it is basically all risk, with very little reward." There is little that can be misinterpreted in the bolded statement. And while many have taken the other side of the Fed over the past 3 years, few have dared to stand against Paul Singer because if there is one person whose opinion matters above most, certainly above that of the Chairsatan, it is his.

It would be odd to suggest that one of the most scathing critiques of the ECB's attempts to talk up the market on nothing but hope, promises and expectations would come from rating agency Moody's, yet that is precisely what has happened. With Swiss, Dutch, Finnish, and German short-dated bonds once again hitting new record low (negative) rates (and Italian 10Y is weakening), it would appear that at least some of the market is not drinking the all-things-risk kool-aid.

Given the anticipation that is now built-in for next week's ECB meeting, we hope that Draghi has a little more up his sleeve than reviving the Treaty-testing, bondholder-subordinating SMP. Presented with little comment is the market's reaction during the last two periods of buying as it seems that Italian and Spanish bondholders are more than happy to know that there will always be a buyer no matter how much they keep selling their exposure down.

Wondering what Draghi really meant this morning when he spoke at an informal Investment Conference? Apparently nothing just as we said first thing this morning: IMF SAYS DRAGHI'S REMARKS ARE A WELCOME REITERATION OF ECB'S WELL-KNOWN COMMITMENT TO DO WHAT IS NECESSARY. So now the talking down of expectations, or in this case today's iteration of "baffle with bullshit" begins. Yet surely there is some additional agenda. For the best interpretation of what the ECB head said, we go to his former employer, Goldman Sachs, which is always ready to tell its clients to do the opposite of what its own prop desk is doing.

In fact, the only thing that can circumvent the price cycle is QE3.

In his testimony over the last two days, Bernanke has listed the 'fiscal cliff' as one of the two greatest risks to the US economy, along with the situation in Europe, and urged Congress to enact 'earlier rather than later' a plan that achieves 'short-term and long-term objectives,' with the primary short-term objective to adjust the timing of the near-term fiscal contraction "to allow the recovery a little more space to continue." . However, like us, Goldman believes that resolving the two key issues - the fiscal cliff and the need to raise the debt limit - will be more difficult than it was last year, for three reasons: (1) the "easiest" options to lower the deficit have already been adopted, so the remaining options touch more controversial areas than those enacted last year; (2) some members of both parties have indicated that they regret the agreements reached in 2010 and 2011, implying less willingness to compromise this year, and (3) both parties appear to be contemplating strategies that involve allowing most or all of the policies to change at year end, as a means to achieving their ultimate policy goal. Stunning! Sure enough, as debate on the fiscal cliff gets underway in earnest, the tone of rhetoric has predictably worsened. We suspect the only way they will ever agree is after the market makes it clear that any other path is unacceptable.

All day long we are bombarded with surveys of sentiment. When positive; all is well. When negative they are used by any and every long-only manager as yet another money-on-the-sideline-like as justification to be the contrarian and buy-the-dip. There are however many times when the survey of people's 'views' is quite different from their positioning (cognitive dissonance aside) and we prefer to look at real market sentiment indications for our signals. Case in point is CSFB's Fear Index - which, unlike VIX, measures the sentiment skew in options prices (how much more bearish or bullish put options are relative to call options). In general, it shows a slight leading indication for larger-trend equity movements but most critically - it can signal when real market positions have become too bullish (or overly confident) or too bearish (overly conservative). The fact is that the options markets are NOT currently overly bearish here - as they were in Q4 (green oval) - providing the short-squeeze-levered ammo for a rally here; just as options markets were overly bullish (red oval) as the end of LTRO2 began - which provided the initial levered-long-squeeze ammo for the current sell-off. So the next time you hear someone saying how negative sentiment is - and that's a reason to buy - show them this chart (of real positions - not a survey!) and tell them to move along.

European equities have been grinding lower throughout the European morning, with basic materials seen underperforming following the release of a multi-month low Chinese CPI figure, coming in at 2.2%, below the expected 2.3% reading. The focus in Europe remains on the Mediterranean periphery, as weekend reports from Spanish press suggest that the heavily weighted Valencia region may be pressed into default unless it receives assistance from the central government. The sentiment is reflected in the Spanish debt market today, with the long-end of the curve showing record high yields, and the 10-yr bond yield remaining elevated above the 7% mark. News from an EU council draft, showing that Spain is to be given extra time to meet its deficit targets did bring the borrowing costs off their session highs, but they do remain stubbornly high at the North American crossover. The gap between the core European nations and their flagging partners continues to widen, as Germany sell 6-month bills at a record low of -0.0344%. As such, the 10-yr government bond yield spread between the Mediterranean and Germany is seen markedly wider on the day.

And some thought we were only kidding that NIRP is soon going to be Europe's new best friend. Also, if the former employer of Mario Draghi is now saying a rate cut is imminent, it means that the fiscal pathway to resolution is dead and that Friday's summit will be an even bigger disappointment than everyone now expects.

We have discussed the use of correlation (cross-asset-class and intra-asset-class) a number of times in the last few years, most recently here, as a better way to track 'fear' or greed than the traditional (and much misunderstood) VIX. As Nic Colas writes this evening, a review of asset price correlations shows that the convergence typical of 'risk-off' periods in the market is solidly underway. While we prefer to monitor the 'finer' average pairwise realized correlations for the S&P 100 - which have been rising significantly recently, Nic points out that the more coarse S&P 500 industry correlations relative to the index as a whole are up to 88% from a low of 75% back in February. In terms of assessing market health, a decline in correlation is a positive for markets since it shows investors are focused on individual sector and stock fundamentals instead of a macro “Do or die” concerns.  By that measure, we’re moving in the wrong direction, and not just because of recent decline in risk assets.  Moreover, other asset classes such as U.S. High Yield corporate bonds, foreign stocks (both emerging market and develop economies), and even some currencies are increasingly moving in lock step.  Lastly, we would highlight that average sector correlations have done a better job in 2012 of warning investors about upcoming turbulence than the closely-watched CBOE VIX Index.  Those investors looking for reliable “Buy at a bottom” indicators should add these metrics to their investment toolbox as a better 'mousetrap' than the now ubiquitous VIX.

Jose Manuel Barroso, President of the European Commission, thinks Europe needs a unified banking system.

But how can financing be a solution for a Zone with a fatal fundamental flaw? Banking cannot save the euro-Zone. This proposal is only the distraction du jour.

Europe continues be unable and unwilling to look at the core problem in the Zone which has morphed into huge competitiveness differences that are creating havoc.

The easiest fix for this is a break up. For the Zone to survive this will require a lot of cooperation and frankly it does not seem close to doing it.

All you need to read and some more.