The T Report: Ruby Red Slippers

For 2 days, the markets bought the dip in spite of negative economic data and signs that nothing has been fixed in Europe and that Spain could quickly become another problem.  Right now a lot of bulls are clicking their heels together and hoping to get back to the highs.  That is a very risky strategy.

China is getting worse. Europe was never better, the data is confirming that, and Spanish yields are attracting attention, while more and more investors realize that Portugal will also need PSI, and will want it sooner rather than later.

 The US data is only okay.  It seems to have stalled out at decent levels, but no longer surprising to the upside, and more and more signs appear that the weather merely pulled demand forward rather than truly jumpstarting the economy.

Then, there are the signs that the market has become very complacent.  VIX is as low as it was last July, right before the crisis.  Price targets on stocks (particularly AAPL) are being ratcheted up almost daily.  Two big dealers said to sell bonds and buy stocks – yesterday.

Even in the credit markets, the signs of complacency are there.  For me, the fact that IG18 was trading 7 bps rich yesterday was a sign that the rally was overdone and we recommended shorting it for a trade, I would keep that short on still.  7 bps is a lot to give up for the “liquidity” of the index, when the index is trading at 85.5 bps.  It is trading at 88 right now, and that is still largely from the “richness” going away than any significant single name weakness.  The “buy the dip” mentality is still strong, but if we can’t get a strong bounce today, we may see some nervous longs get out here.  Another sign of complacency was that bid/offer spreads on runs had been shrinking – what better way to get the street caught on the wrong side of a move than by increasing their risk taking and making bid/offers too tight relative to the size of the moves.

 The Spanish 10 year bond may be the key to today’s trading.  It is bouncing off the lows, but I don’t think that is sustainable, without some good ECB buying rumors.  I wouldn’t be surprised to see a similar pattern in US trading, as we open lower, struggle to bounce, linger, and then….  Well I think the end will be a lower close, but I have learned not to underestimate the ability of the ECB to get involved and try and stop this weakness before it gains too much momentum.

 To me, the solution for Europe remains clear.  As Trish Regan and I discussed yesterday, Ireland, Portugal, Spain, and even Italy and possibly Greece (again) need to embark on immediate debt restructurings.  That is the only way to get the debt down.  Austerity and spending aren’t working, so restructure.  The Greek PSI showed that they countries can push programs through and it is now time to protect the sovereigns at the expense of the banks.  Don’t wait for a year and make things worse, like Greece did, do it now.  The share prices for banks will bear the brunt of the pain.  LTRO ensure that solvent banks won’t face a liquidity crisis, but it won’t save their share prices if the EU embarks on this restructuring program – the only one that is guaranteed to put the sovereign debt crisis behind us.  I would avoid European bank shares because their equity value will make an appealing target for sovereigns trying to get out of their debt mess without putting more burden on the taxpayers.  If European banks get hit, US ones will as well, maybe not so much directly, but as a relative value play, so I would be cautious there as well.

 I still like long HY17 vs HYG, though there could be some interesting trading opportunities around that today and tomorrow if disconnects between the “institutional” CDS market and “retail” ETF market occur.  With some high beta European hy bonds already down 2 points, and liquidity hard to find, we could see some dealers and institutional investors look to trade the ETF’s as a hedge.  Hedge funds and the ETF’s have all piled into the most “liquid” bonds, watch those as the liquidity premium may quickly become a curse.  European XOVER index, which is a HY index in Europe is in trouble today – it shows how quickly the price action in credit can change.

 E-mail:    tchir@tfmarketadvisors.com  Twitter:  @TFMkts