Spain & Italy Moving Closer To The Edge

Topics Covered

• Silver price presents a good trade setup, but in which direction?
• Spain and Italy are moving closer towards the edge of the cliff

Overview

The selling pressure has stopped for now as risk assets and safe havens both move in sideways patterns. It seems that the S&P 500, Crude Oil and Gold are now in a rebound rally of some type. Sentiment reached extreme negative levels on all of these asset classes over the last several weeks. On the other hand, safe haven assets like US Dollar and Long Bond have paused their vertical rise and have entered corrective mode as those trades become overcrowded.

It seems we are entering a period of mean reversion but the bottom line still remains the same: investors have been selling risk due to possibility of a disorderly default in Eurozone, triggered by Greece as the first domino, followed by Spain and Italy contagion effect. At the same time, Asia and especially China is slowing down meaningfully. At present, bearish trades remain very crowded.

Economic Data

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Equity Markets

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Bond Markets

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Currency Markets

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Commodity Markets

Technically, Silver is presenting a good trade opportunity right now. Over the last few days the price has gone dead quite and is now most likely ready to break out in either direction. The chart above shows important technical levels to watch including important technical lines, like the major downtrend line which started in May 2011, as well as the smaller minor downtrend line which started in early March 2012. COT positioning has been reduced to very low levels in recent weeks and Public Opinion is also very low. Both of these indicators tell us that Silver's upside has more potential and/or probability, but the question is always about timing.

I purchased Call options on various Silver ETFs in both middle and end of May, but have recently closed them because the bounce I expected from the $26 support has not been as "vigorous" as I initially thought. Another reason I have closed these Calls, is because the consensus investors, or as I call them Dumb Money, have been accumulating Calls over Puts on both Gold and Silver as well. Some of the people I have read comments from quote "Rothchild's buying" as the reason to buy Gold and Silver right now - now that is quite creative. While options positioning is not a major red flag, it still warrants caution, as I prefer to be a on the minority or contrarian side. If the price was to break in either direction from the recent triangle, I am willing to participate in a trade.

Credit Markets

As you have most likely already heard, Spanish 10 Yr yields have now exceeded 7% for the first time since Euro was introduced in 1999... and this comes less than one week after the bailout. In other words, markets have lost patience and recovery rallies based on intervention (LTROs, Twists, Bailouts) are now buying less and less time. The chart above shows a worrying picture of short term funding costs for both Spain and Italy. These rates are much much more important than the rates on the 10 Yr bonds. I am afraid that both of these large economies, which are already in a recession, are now moving towards the edge of the cliff.

At the same time, Dollar funding costs have not yet started to increase substantially. The chart above shows no major Dollar liquidity problems within the market environment right now, as 3 month Euro Dollar swaps are hovering around 54 basis points. Nothing as dramatic as we saw during October 2008 or October 2011. This leads me to a conclusion the Draghi's LTRO has reduced the financing needs for the time being.

Finally, currency swap spreads over two years, which are a great barometer of systematic risk within the banking system, remain very low in the United States, while still very elevated in Europe. Readings of 83.35 basis points (current EU level) resemble 2008 type outcome scenarios and warrants great caution ahead. Having said that, recent price movements seems to be quiet positive over the short term, which makes me conclude that the LTRO has postponed the banking problems in the EU for now. 

Trading Dairy Updates

• Summary: 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 while Asia is now in a meaningful slowdown.

• I have closed all shorter term trades (including options) from SPY to SLV to RJA. However, I am also still holding onto that core Silver position from late December 2011 bottom at $26.
• Greek election and G20 on the weekend, followed by FOMC meeting early next week all provide some forms of catalyst to move oversold and over bearish risk assets in either directions. I'm currently sidelined trading until further clues.
• Risk assets still remain on my watch list for some shorter term bullish rebound trades. These include Brent Crude (BNO), Commodity Indices (GCC / RJI), Precious Metals (GLD, SLV, CEF, PSLV, etc) and Agriculture (RJA). I believe commodities are very oversold right now and should ounce soon.
• I am waiting for a market rebound first, before engaging into some shorts, as a believe equity bear market is here.