Diary of a Financier

Marketplace Observations

In Capital Markets on Tue 26 Jul 2011 at 08:16
  • LIBOR rising in divergence with IRX.
  • The extreme inverse correlation between Italian yields & IRX plus Italian yields & EURJPY explain much of the capital flight from Europe.
  • Waiting for EWI to establish a top to its daily trading range before opening a short position to hedge my long US exposure.
  • US will arrive at a debt deal (likely the Reid plan ok’d by S&P), but Europe is irreparable.

Just some random observations that I wanted to regurgitate before the day starts.

First, 12-month LIBOR is rising in neat cooperation with my expectations:

LIBOR 12-month

I’m aware of the term mismatch in what I’m about to say, yet I have to note the divergence between that 12-month LIBOR & 3-month Treasury Yields (IRX):

LIBOR v IRX- LIBOR rising as expected, but T-Bill rates still held back by European crisis

There’s a noticeable uptick in 3-month LIBOR too, but it looks more like a short-term oscillation, a hiccup.  As longer-dated LIBOR is moving deterministically higher, IRX looks pinned by the crisis in Europe.  Money Market Funds sought European bonds to get a bit better than zero yield; now that money is scurrying back to American paper.  I overlay IRX v. 3-month Italian yields to illustrate the inverse correlation:

IRX v 3-mo Italian Yield

Note how extremely negative the 100-period rolling correlation (-0.554) is for that pair.  Further, note the cascading drop in IRX since New Year’s Day, as opposed to the sharp spike in Italian rates.  Explaining the balance of that inverse correlation, JPY has also soaked up some of that capital fleeing from Europe in a great unwind of an epic FX carry trade.

There’s more to discuss in this regard.  More importantly, however, I’m ready to derisk a portion of the portfolio, so I want record my thought process about my upcoming market activity first.  I don’t want to unload a big chunk of my long positions, because I’m certain some US debt deal will happen. While US Treasuries won’t remain unscathed, stocks will find a way to shrug it all off.

I therefore want to short a broad index to net out the relative strength of my longs and protect against catastrophe.  The S&P 500 ETF (SPY) would be an obvious choice, but I find a better technical setup in the Italy ETF (EWI):

SPY v EWI daily- Italy ready to short once it’s established a top to its trading range.

SPY v EWI monthly- hopelessly bearish for Italy.

I’m waiting for a trigger before opening a short EWI position.  Technically, the daily fractal should establish a top to its trading range within days to weeks.  I worry about a weekly fractal that looks like it has bottomed.  I’ll have to monitor that chart to watch it develop.  I will note that the weekly is still stuck in a bear trend channel.  (EWI is also a bit expensive to borrow at 4%, compared to SPY at 3%.)

I regard the American situation as avoidable, fixable, or, at very least, sweep-under-the-rug-able.  Harry Reid is onto something, and by virtue of having the only palatable plan on the table, he might get the nod from fellow Democrats plus the ratings agencies plus Messrs. Boehner & Cantor. Europe has no chance.  At this point, neither EFSF supra-national bond issuance nor a European Monetary Fund has the magnitude to reverse the demise forecast by fundamentals, history, and the long-term charts.  When a sovereign is tapped by the Reaper, he cannot escape death without renouncing his sins.  The Original Sin for the Euro fringe was marrying into the EMU for a large dowry.* Fiscal Union can start to mend these travails if Germany & France are willing to access credit markets at interest rates that reflect a higher weighted average, accounting for PIIGS subprime credit worthiness as of today.   That’s in stark contrast to PIIGS having accessed credit markets at interest rates that reflected the prime credit worthiness of Germany throughout the decade.  I’m suggesting that Germany & France will have to [largely] foot the bill in recapitalizing the PIIGS.  That’s a substantial bill.  That’s not worth the synergies of a Eurozone.

John Hussman did some eye-opening math for us this evening:

For most countries in Europe, government revenues typically run between near 40% of GDP, while government spending presently runs several percent ahead of that. In Greece, government debt now represents about 150% of GDP at interest rates between about 10% for very short and very long-maturity debt, to about 25% annually on 2-year debt (reflecting a high expectation of default). The overall average yield on Greek debt is close to 15%. The problem is that 15% interest on 150% of GDP works out to 22.5% of GDP in interest costs if the debt actually has to be rolled-over without restructuring it. That would be more than half of the government revenues of Greece. The only way Greece can avoid default with that math is if investors quickly become willing to roll over the existing debt at an interest rate in the low single-digits.

Not to critique someone of Mr. Hussman’s stature, but the critical pitfall of fundamentals is that they’re a static gauge used to analyze a dynamic market.  A 5% rally in Greek debt over the next 48 hours would eradicate all of his arithmetic.  His point is well taken, nevertheless.  A short position in Italy will serve as a hedge for me, not an unchecked short.  I find relative strength in the US from both a technical and an anecdotal approach.  The short interest is concentrating European floats–something I have to be mindful of.

–Romeo (hattip Cullen Roche)

*I don’t get why they taught me to avoid mixed metaphors?!  They’re as amazing as split infinitives.

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  1. […] my musing from earlier this week: I’m waiting for a trigger before opening a short EWI […]

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