Eurozone Recession Intensifying

Topics Covered

• Eurozone recession intensifying & spreading
• Treasuries are historically at major extreme
• Record bullish Dollar bets increase further
• Italian & Spanish credit situation still worsening

Overview

The selling pressure has claimed in risk assets, however recovery rallies - if even present - remain very dull. US equities and Gold have bounced modestly, while Crude Oil still struggles to find support. Treasuries are still sitting near all time record high prices, while the US Dollar has broken above resistance at 82. With such large bullish bets, it remains to be seen if this breakout in the Dollar will be real. The bottom line still remains the same: investors are selling risk due to possibility of a disorderly default in Eurozone, triggered by Greece as the first domino. At the same time, Asia is slowing down meaningfully. Nothing has been done, announced or hinted by authorities yet and risk off trades are very crowded. Short squeeze could occur at any point in time.

Economic Data

European recession is intensifying, that is for sure. Officially, over one third of European Union members are now in technical recession. Unofficially, I'd argue that probably just about all of them are and so would the falling Euro currency, falling Euro Stock 50 stock prices and falling Bund yields.

Italian Business Confidence continues to deteriorate at the fastest pace since 2008 recession and there is still no sign of a trough. Italian GDP could get more negative soon, putting pressure on borrowings costs (more on that in the credit article below). Italy is a very good barometer for Southern European economies, so as we see confidence plunge here, we can also be sure that the situation from Spain to Portugal and Greece is most likely much worse.

Furthermore, this is now spreading into the EU Core countries. While France is not officially in a recession just yet, French PMI manufacturing is signalling that countries output levels are about to start falling much faster than originally thought and currently reported.

Many of you would be saying... well, we all sort of knew this, so what is your point? While many economists expected some type of recovery by now, the European recession is spreading across the continent. But that is not all. Since Europe is Asian main customer, it seems that the European recession is now also slowing down Asia too. If you are getting a feeling of a deja vu, than I do not blame you.

You see, in 2007 US housing started to fall apart affecting subprime companies. This spread into the US finance system and started affecting major global banks. Eventually, US entered a recession in late 2007 and it started to spread towards Europe. Finally, a mild recession escalated into a Global Financial Crisis affecting Asia too. Throughout the whole ordeal, the word "de-coupling" was constantly used by the bulls.

Today - the starting point is the peripheral Europe (PIIGS) in 2010. Here we are almost year and half later and the crisis is slowing affecting the whole Europe. Even France and Germany are now slowing meaningfully. At present trajectory, it is very possible that Asia is starting to also be affected now too. And "if" we continue down the 2008 road, eventually a global recession could follow once again. However, once again a major word use by the bulls is that the US or even Asia is "de-coupling" from European slowdown. I am not so sure about any of that!

Equity Markets

Nothing new to report.

Bond Markets

Global interest rates move in long term cycles, known as Kondratiev Waves. These cycles last about 50 to 60 years from trough to trough, and from peak to peak. That means, half cycle movements last anywhere between 25 to 30 years. If we look at the chart above of the US Treasury 10 Yr Note Yield, we can draw two major conclusions:

1. After peaking in September of 1981 at above 15%, Treasury interest rates have been dropping for 31 years. Therefore, we are eventually overdue to a major trough in rates, from which a grand secular Bond bear market will start (rising rates for about 25 to 30 years).


2. Treasury rates have been trending lower in a basic bearish channel, but ever since the Eurozone Crisis started in late 2009, capital flight has found its way into Treasuries on a major scale. As foreigners continue to pile into this "safe haven", it is starting to look extremely overbought from historical perspective and in a major terminal blow off move, that will eventually mean revert.

Having said that, from the short to medium term perspective, as long as there is no resolution in the Eurozone, Treasuries remain favoured by global investors and could benefit further. Also to note, with possibility of a global recession looming and Asia slowing meaningfully, Treasuries could also benefit for awhile longer - as there is no alternative for the time being. Just like all bubbles, they tend to go much further than anyone can imagine. But be warned that eventually, this grand 30 odd year secular bond bull market will end. And when it ends, mean reversion in interest rates will be very violent.

Currency Markets

Over the last week or two, I have discussed in various articles how traders and investors are very bullish on the US Dollar at present. On Friday, another Commitment of Traders report became published and it showed more of the same, but with further extremes. It is very interesting to see that overall cumulative futures positions showed the largest ever bullish bet on the Dollar. As we can see in the chart below, the market holds close to quarter million contracts, anticipating further greenback appreciation.

If we break down the data, we can notice that Euro and Australian Dollar now hold historical record net short positions. Market turned short New Zealand Dollar for the first time in quarters, Swiss Franc shorts intensified dramatically, while Yen's short positions have been reduced. Hedge funds are still slightly net long the Pound and the Loonie, but I think even those have been reduced further as last week progressed with more selling. The chart above shows that whenever investor quickly pile into Dollars, at least a correction tends to follow.

Another observation should also be considered. If we look at the chart, we can notice that there has been no terminal move (vertical panic rise) in the Dollar with such extreme bullish sentiment. Current price action is not extreme and doesn't signal a trend change right now. Therefore, I am not yet ready to re-enter Dollar shorts, even though I expect the Dollar to correct very soon.

Commodity Markets

Nothing new to report.

Credit Markets

Majority of market participants focus on PIIGS 10 Yr Yields or the spread of those bonds against the equal maturity of German Bunds. This helps them gauge the risk effects that are occurring with the government bond markets. However, I think there is a more important indicator to follow, and that is the short term funding costs that these countries are currently paying when they issue bonds.

In the chart above, we can see that Spanish 2 Yr borrowing costs now stand at 4.34% while the Italian 2 Yr borrowing costs stand at 3.93%. Despite the LTRO program, which made short term funding costs fall temporarily, we are now back to same old again, where short term borrowing costs are at or above 4%.

There is not much too say regarding this apart from emphasising that we are now entering a very dangerous situation. Yes... money printing has kicked the can down the road and it could do so again, but each time that kick seems to be weaker and weaker. If the situations deteriorates further, where short term 2 Yr borrowing costs keep rising towards 5%, a major crisis in Europe could be waiting for us all around the corner.

Credit Default Swaps are also showing a similar picture of worry. While the LTRO program kicked the can down the road by quarter or two (which ever one you want to pick), Spanish CDS are once again making new highs and are now approaching 550 basis points, while Italian CDS are not too far away from their all time highs made late last year.

Finally, when we look at the banking systematic risk in both the United States and in Eurozone, we can see a picture of two different situations. European 2 Yr currency swap rates are close to levels we have seen during Lehman Brothers panic. This tells us that a possibility of a banking failure somewhere within the Eurozone remains very very high. On the other hand, the picture in much claimer in the US for now.

Recommandations

• My further action depends on political and central bank intervention. During market panics, authorises also panic. It is not until they start to panic, that they actually do something about current problems, which usually take form of some type of reflation policy. However, weak action will make me reduce my longs substantially and rebalance my portfolio towards net short exposure. Italy and Spain are once again moving towards the edge of the cliff, which is a real worry!
• I still own SPY Calls from earlier last week, so I will not be doing anything in the Equity market for now. I own no other equity positions.
• I also still own SLV Calls from two weeks ago, so I will not be doing anything in the PMs market for now either. I also own a core Silver position from late December 2011 bottom.
• I am still looking at Agricultural commodities, with RJA being my favourite way to own this sector. I haven't done anything yet.
• Other assets on my watch list for some shorter term bullish rebound trades include Australian Dollar (FXA), Russian / Brazilian equities (RSX & EWZ), Gold & Silver physical ETF (CEF), Gold mining equities (GDX / GDXJ) and Continuous Commodity Index (GCC). I haven't done anything here either.
• It is too early to talk about shorting anything yet, as I am waiting for a market rebound first.