ECB Actions Will Drive the Market. Ignore the FOMC Move and Wait For the ECB Thursday.

August 1, 2012
Author: Peter Stolcers, Founder of OneOption
Author
Pete

After a big rebound last week, stocks are taking a breather. The first round of news was decent and the market is treading water.

Global PMI’s were in line. China’s number was 50.1 and Europe’s was 44. China’s Finance Minister said that they will ease in the second half. Their market is at multi-year lows and many analysts believe they will lower bank reserve requirements three times and they will cut rates twice by the end of the year. Europe is in dire straits and the ECB will release its statement tomorrow.

Treasury Secretary Geithner is urging the EU/ECB to lower interest rates for PIIGS. Last week, ECB President Draghi said that they will do whatever it takes and the action will be material. The ECB’s statement tomorrow will set the tone for the market.

It is possible that the EFSF/SMP will use the ECB’s trading desk to purchase sovereign debt. This would temporarily lower PIIGS yields. Unfortunately, the EFSF/SMP will constantly have to ask EU members for more money. If the bonds represented a good value, private investors would participate and they would not need the EFSF/SMP. That’s the problem. Structural deficits caused by entitlement make them a risky investment. European banks are up to their eyeballs in sovereign debt and they have reached their limits.

LTRO3 is another possible outcome tomorrow. The ECB will lower collateral requirements and European banks will pledge substandard assets in exchange for Eurodollars. In theory, they would use this money to purchase sovereign debt. These loans need to be repaid in three years and banks will stay on the short end of the yield curve. Spanish and Italian interest rates have spiked and LTRO1/LTRO2 have been ineffective. If this is the great solution, the rally will be temporary.

Andrea Merkel (Germany) and many other Eurocrats are on vacation. I am not expecting any monumental news regarding a centralized bank for the EU or fiscal reform policies. We can expect promises that progress is being made on these fronts.

This afternoon, the FOMC will release its statement. Traders are expecting “dovish” rhetoric after Ben Bernanke’s testimony before Congress two weeks ago. They will want to hear that QE3 is being considered in the near future (September). Anything less will result in a negative reaction.

ADP reported that 163,000 new jobs were added to the private sector in July. This was much better than the consensus estimate of 125,000. ISM manufacturing was slightly below expectations and it came in at 49.8. That level still indicates economic contraction.

Initial claims have been volatile and there are many seasonal adjustments. Judging from the ADP release, Friday’s number might hit 100,000 (consensus estimate).

The driver will be the ECB’s actions tomorrow. If the market likes what it hears, interest rates and Italy and Spain will decline. That will set a positive tone for the market.

Unfortunately, the long-term demand for Spanish and Italian debt will be low. The EFSF/SMP/LTRO3 will only cause a temporary decline in interest rates as shorts are forced to cover. Financial institutions and private investors will not be buying these bonds and the EFSF/SMP will become the buyers of last resort. The market could rally in the short-term. The strength and momentum of the move will indicate the duration.

If we get a sustained rally and we convincingly breakthrough SPY $142, the market could grind higher. On the other hand, if traders realize that this is just another Band-Aid, we will quickly test SPY $142 and fall back.

There seems to be a bid to the market and it is always dangerous to short during light volume conditions.

I’m not changing my tune; I still believe that trouble lies ahead. I want to buy puts, but I don’t want to be early.
Novice traders feel like they have to catch every move to be successful. If they miss a rally, they feel like they should have seen it coming. After 25 years, I have learned that it is fine to be on the sidelines. It is impossible to predict how the market will react to the ECB’s “warm fuzzy” and I will sit this one out. If I miss the rally or I miss a great entry point to get short, it’s OK. Tomorrow I will have more information and I can make a better decision.

Be patient and keep your powder dry. The reaction after the ECB’s statement will be very telling.
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