This morning’s auctions appear to be nothing short of spectacular. Low rates, big size, follow through at the long end of the curves Italian 10 year yields are 40 better on the day and almost 60 better on 2 days as the yield is back to 6.56%. SOVX is 10 tighter (though it is hard to tell if anyone bothers trading that anymore). Main is 7 tighter, back to 170, and SNR Fins are once again outperforming as they are at 266 and 14 tighter on the day. Frankly, the reaction in stocks is muted, particularly in S&P futures which are up less than a ½% from their overnight lows, and barely up 0.25% from the close.
Stocks may continue to rise, and they may be nearing a “breakout” range, but the muted reaction is some evidence that “muddle through” and “decoupling” are fully priced in. It does seem that the number of bearish comments far exceeds the amount of bearish positioning. The equity markets may also be pricing in the fact that heavily manipulated auctions aren’t a valid signal of strength.
The auctions should be Euro positive, and given how crowded the short Euro trade is, that could spike nicely and with reduced correlation may not drag stocks up as much as it would have in the past. I like the Euro here relative to stocks.
I think the ECB will leave rates unchanged. Germany issued bonds with negative yields. The LTRO program just started and there is little need to cut that already low rate by much, especially when so much of the money is still sitting at the ECB (I expect that some will finally have been used to play in these auctions). They may want to save some ammunition for later when the market is actually weak as opposed to a time when we are hitting new recent highs. So I don’t expect a rate cut.
I don’t think the market does either. A rate cut would be a surprise, so the market shouldn’t react much to an unchanged decision. It could be positive for the Euro though. Signs that they don’t feel the need to cut rates could take some selling pressure off the Euro, and again, the potential for short covering seems very high. A rate cut may create a brief rally, but I think that might actually fade quickly as investors wonder how much worse things are than they seem.
SMP or QE
Draghi will downplay the potential for QE. Not only will he not say they are going to increase the program, he will downplay the potential. They haven’t wanted to do QE (they don’t really believe it helps the real economy) and now they have the excuse. The auctions went well. LTRO is up and running and there is another tranche coming up in February. They will really go out of their way to demonstrate that QE or increased SMP is off the table.
I think this will disappoint the market, but only mildly. The strong auctions will be enough to reduce the impact from the ECB shooting down QE expectations, but I think the market will fade on that news, if only a little. I’m not sure how the Euro will react, in theory no QE should be positive for the currency, on the other hand, the mention of QE has been positive for the Euro enough times that the FX market reaction to this specific outcome is unclear.
I am biased to be long Euro, continue to be short the “decoupling” trade (ie, I like long Europe vs short US), and still have an overall short bias. Financials look like they could run further and I expect JPM to have good earnings. They were far more conservative on booking DVA profit last quarter and probably have a lot of wiggle room on reserve releases to produce a nice quarter, though they may want to save it for this year since last year’s bonus pool isn’t likely to get much of a bump from that.