European Debt Contagion Grows

The Fed “Twist” remains in place, with the prospect for QE-3 ultimately coming to fruition as several top FOMC members want it. Now, the European debt contagion is growing, and the world economy is decelerating — including China. Collectively, given the bearish sentiment extant...this should have allowed for stocks to climb the Wall of Worry leading into Christmas — but it hasn’t...a distinct and material negative.


STRATEGY: Technically speaking, the S&P 500 remains above longterm support at the 45-mema at 1190; which is critical given it delineates bull & bear markets. However, major support at 1217 was given in bearish fashion, which supports a test of the 1190 level and perhaps breakdown in the weeks ahead. Our models have now turned lower in a bearish configuration, which means rallies are to be sold going forward.



EUROPEAN MARKETS ARE FEELING RATHER “BRISKLY BETTER” THIS MORNING as German and French bourses lead all bourses. The reason is rather clear: Spain was able to auction off both 3-month and 6-month bills at 1.735% and 2.435% respectively. These are far better than those seen at the previous auction of 5.110% and 5.227%. Too, the Spanish government was able to auction off €5.6 billion rather than the proposed €4.5 billion. This is giving rise to “hope” that perhaps the European authorities have this under control in a very strange way. Nothing could be further from the truth, and we see what strength there is in the German and French markets dissipating in the day ahead, with the current S&P rally of +12 points failing as well. Lastly, we should note that the S&P futures – including today’s rise, will have opened up strongly in the past four morning sessions. In the previous three…those gains were all given back and losses incurred.

THERE ARE SHARKS IN THEM THERE WATERS…The ratings agency Fitch has provided the following statement:

Following the EU Summit on 9-10 December, Fitch has concluded that a ‘comprehensive solution’ to the Eurozone crisis is technically and politically beyond reach…

This doesn’t bode well for the ratings of the various Eurozone countries, and indeed we’ll see more headlines in the future about sovereign debt as well as banking system risk. The “great downgrade” is upon us. Those who



would like to read a bit more of the Fitch report should read below:

Following the EU Summit on 9-10 December, Fitch has concluded that a ‘comprehensive solution’ to the eurozone crisis is technically and politically
beyond reach. Despite positive commitments by EU leaders at the Summit, notably the decision to accelerate the creation of the European Stability
Mechanism (ESM) and to place less emphasis on private sector involvement (PSI), the concerns held by Fitch prior to the Summit remain pressing and have not been materially eased by the Summit outcome (also see, ‘Summit Does Little To Ease Pressure on eurozone Sovereign Debt,’ 12 December). Of particular concern is the absence of a credible financial backstop. In Fitch’s opinion this requires more active and explicit commitment from the ECB to mitigate the risk of self-fulfilling liquidity crises for potentially illiquid but solvent Euro Area Member States (EAMS).

Fitch recognises that the policy authorities in all of the countries with sovereign ratings subject to review have embarked upon significant fiscal consolidation and structural reform and these efforts will be taken into account in the review. However, the systemic nature of the eurozone crisis is having a profoundly adverse effect on economic and financial stability across the region and for some EAMS poses near-term risks that are beginning to dominate the sovereign-specific risk fundamentals. Today’s announcement is focused on those sovereigns that are potentially vulnerable to the worsening external economic and financial environment as indicated by previous negative rating actions and rating Outlooks.

The RWN is prompted by the following risk factors: - In the absence of greater clarity on the ultimate structure of a fundamentally reformed Economic and Monetary Union and the recognition by political leaders of the potential for an EAMS to leave the eurozone, Fitch will review its assessment of the balance of risks associated with eurozone membership, especially for sovereigns potentially subject to funding stresses.

- While acknowledging the extraordinary measures the ECB has adopted to provide liquidity to the European banking sector, its continued reluctance to countenance a similar degree of support to its sovereign shareholders undermines the efforts by EAMS to put in place a credible financial ‘firewall’ against contagion and self-fulfilling liquidity and even solvency crises.

- The intensification of the eurozone crisis since July constitutes a significant negative shock to the region’s economy and the stability of its financial sector with potentially adverse consequences for sovereign credit profiles across the region, most immediately for those placed on RWN today. - In the absence of a ‘comprehensive solution’, the crisis will persist and likely be punctuated by episodes of severe financial market volatility that is a particular source of risk to the sovereign governments of those countries with levels of public debt, contingent liabilities and fiscal and financial sector financing needs that are high relative to rating peers.

TRADING STRATEGY: We are flat, and we have been comfortable being so, but today’s rally is sufficient to bring us off the sidelines to test the short waters as the 1217-to-1220 resistance zone lies above the market, and we’ll not expect the S&P to be able to mount this level for very long if at all – giving way to downside selling pressure. This, coupled with the increasingly slow Christmas volume – can increase volatility rather greatly if one of the ratings agencies decides to play Grinch before Christmas. We’ll look to add to the trade once the lows of yesterday are taken out.

To read the entire report please click on the pdf file below.