Watch the ECB Thursday. Jobs Won’t Be Much of A Factor. China Could Be the Next Problem.

September 4, 2012
Author: Peter Stolcers, Founder of OneOption
Author
Pete

This week we might actually see some action. During the last month, the news has been light and European credit concerns have subsided.

There have not been many headlines over the extended weekend. The PMIs in Europe and China were weak, but in line with expectations. Rumors circulated that the ECB feels that it can purchase sovereign debt that matures in three years without violating any rules. This duration is longer than most traders have been looking for (1 to 2-year notes) and the news was mildly bullish.

This Thursday, the ECB will release its official statement. Traders want details. We know they plan to support short-term sovereign bond auctions through the EFSF. We don’t know the magnitude of the program and we don’t know if the ECB has a yield target. We probably won’t ever know these specifics because they don’t want to show their hand. Traders are also expecting to hear about a centralized banking system in Europe. That plan should be released in the next few weeks.

Draghi has been able to pacify the market with lip service the last few weeks. If he does not deliver specifics, the market will decline.

The situation in Greece is tenuous and meetings are being held with the troika. Tax receipts are down and spending cuts are behind schedule. Deficit targets will be missed by a wide margin and German officials are being asked to tone down the rhetoric as they discuss how to minimize the effects of a Greek default/departure.

The ECB’s Band-aid could actually work in the short-term. If institutional investors feel that the debt will be “backstopped”, they will buy short-term bonds. Spain and Italy will focus on maturities that are less than three years in duration and all of their debt will be rolled forward. At some point (2013), structural deficits will force yields higher and the ECB/EFSF will not be able to keep a lid on them. I am very focused on what might happen in the short run and I will be able to gauge the market’s reaction this week.

Central banks around the world are artificially supporting economic activity. Last week, the Fed Chairman paved the way for QE3. Wisely, he did not set a timeline. As soon as the market gets that news, it will be looking for its next “fix”. China has been easing, but economic conditions are deteriorating and they have not jumped into action. They have the cash to stimulate the economy through fiscal spending and those projects have developed slowly. China’s PMI was weak and the PBOC did not lower rates. China’s stock market is making fresh four-year lows.

I believe that China is headed for a sustained economic decline. Long periods of hyper expansion lead to excess capacity and the contractions can be severe. Many commodity producers have seen a dramatic decline in demand as inventories in China grow. A hard landing in China could be the catalyst for the next market selloff.

Economic conditions in the US are flat lining. ISM manufacturing came in at 49.6 this morning. That is slightly below 50 and it indicates economic contraction. ADP will release its report on Thursday and the Unemployment Report will be released Friday. Initial jobless claims have been steady from week to week and I believe the jobs reports this week will be in line with expectations.

If the ECB “pulls a rabbit out of its hat” and China eases, the market could grind higher. This rally will be tenuous and Asset Managers won’t chase ahead of the November elections. The US and Japan are faced with fiscal cliffs and that will also dampen enthusiasm.

If the ECB is short on details, the market will grow impatient and stocks will decline. This selloff will force the PBOC and the Fed to take action.

We won’t have to wait long. Major news events will play out in the next few days and we will be able to take a stance.

I am buying VXX/VIXY October ATM calls and SPY OCT ATM calls in a ratio of 4:1. I am keeping my position small and this is a hedged way to play a market decline. If the market rallies, option premiums won’t drop much and my VXX/VIXY calls won’t lose too much value. Option premiums are all ready at historic lows and they won’t drop much more even if the market rallies. My SPY calls will offset most of those losses.

On the other hand, if the market does sell-off, I believe option premiums will explode. My VXX/VIXY calls will jump and the profits will offset my losses on the SPY calls. If the SPY closes below $138, I will sell the SPY calls and ride the VXX/VIXY calls.

This is a time to be patient. Wait for the news – the market could swing either way.

I have been working on a new trading platform for 3 years and I will be launching it this week. Register for the FREE WEBINAR and see it in action Wednesday night.
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