Can A Move To New Highs Be Far Off?

(By Ed Pawelec) "Who is more foolish: the fool, or the fools who follow him?" Early yesterday morning, around 6 AM New York time, market fears were wiped away.  Relief came in the form of soaring global markets, as concerns about a Greek exit, a full-blown Spanish bailout, and a struggling global economy were laid to rest.

Investors can thank Jedi master Mario Draghi (got my Mario right this time!).  The European Central Bank president's sage words and indomitable confidence sent Spanish and Italian yields tumbling all the way from the danger zone to still unsustainable. 

I am not making this up.  Mario-Wan Kenobi said this during yesterday's "risk-on" press conference.  I guess he won't be going into biology after he wraps up his stint at the ECB.

Seriously, however, what got the markets going was his full-of-confidence (feel free to replace "confidence" with any word you believe appropriate) remarks that the ECB would do whatever it takes, within its mandate, to sustain the euro adding, "believe me, it will be enough."

That was it.  No action.  No specifics on future actions.  But can the calming influence of a Jedi master really send the markets on their way to new highs, or is the upside move set to evaporate as quickly as it arrived?


The Light Saber

The light saber is the weapon of choice for the Jedi, and while Mario isn't a real Jedi, the weapon he has been called upon to use is supposed to have the power of a blade of energy.  I am talking about the Securities Market Program (SMP).

Dreamed up in 2010 to save Greece from the ravages of unsustainable interest rate levels, the SMP is a means to circumvent the ECB prohibition against buying sovereign debt.  Legally, the ECB cannot buy debt directly from or lend directly to a sovereign.  The SMP allows the ECB to purchase government debt in the secondary market from the original buyers of the debt, mostly European banks.

This works by pushing rates on existing similar maturity debt lower so that when the respective governments go to market with an official auction, rates are comparable and low.  Spain, for example, has about €50 billion of funding to raise over the next few months -- bailouts aside.  The Spanish 5 year note was trading north of 7.3% prior to Mario's Jedi mind tricks yesterday.  By the close of European business on Thursday, the 5 year yield was down to 6.57%.

Using an SMP style weapon over the next few months might push the yield under 6% by the time Spain has to go to auction again in September.  As with past efforts, it is a kick-the-can measure that falls apart as soon as the ECB steps away from the markets.

The first round of SMP lasted from May, 2010 to July, 2010 and pushed Greek 5 year yields down from north of 13% to around 8%, but by the end of 2010 yields were hitting new highs.  Currently, there is no liquid market for Greek debt but, according to Bloomberg, the estimated 5 year yield is north of 60%.

With Greece pretty much done for last fall, the target of the second round of SMP was Spanish and Italian debt.  As both countries' 5 year yields shot toward 5.5%, the SMP action initiated in August, 2011 brought both yields down to around 4.25%.  That round only lasted a few months, and by November both Spanish and Italian debt was soaring above 6%.


The Death Star

Since these efforts were clearly ineffective, it was time to bring out the big guns.  In November, the ECB announced its "Long Term Refinancing Operations" (LTRO).  Remember, the ECB cannot buy sovereign debt directly from governments, but it can lend to its member banks and they can do whatever they want.

So Spanish and Italian banks took the domestic government debt it had on its books, pledged it to the ECB as collateral to borrow money at 1% to buy more of their countries' debt yielding 3, 4, or 5%.  The LTRO was so effective that another round was announced in February, 2012.  Both Spain and Italy took advantage of the reduced rates during the first half of the year.  But when the €1 trillion in this easy money shell game dried up, yields were off to the races again.  Just a few days ago Spanish rates were hitting record highs.

The point is that whatever measures were or are taken, the impact is fleeting and is only effective while said measures remain in place.  When SMP, LTRO, QE, Twisting, etc. end, the market's "natural selection" mechanism moves rates and equities back toward more accurate risk adjusted prices.  That cannot be overcome in any lasting sense.

Until a massive amount of debt is simply written off and Europe either falls apart or establishes a credible fiscal union, I will continue to sell the rips, because these rallies are neither sustainable nor the beginnings of a new bull market.

"Your eyes can deceive you, don't trust them."