The real shock came (spoiler alert) when Dorothy and her crew discovered that the Great and Powerful Oz was in fact a little dude who wasn’t all that powerful, but knew a thing or two about creating the illusion of power.
Illusions can be powerful things. They can provide entertainment and awe. My daughter’s eyes would light up when my good friend (who is a terrible magician) would produce a quarter from behind her ear. That lasted until she was about 8, then the green mist lifted and the curtain dropped.
At twelve, she still occasionally asks him to do the trick, but mostly just to giggle and say, “I can’t believe I used to fall for that!”
A powerful illusion can alter our beliefs and influence our actions; this is where yesterday’s Spanish bond auction comes into play.
It is time to peek behind the curtain and make a few dollars.
Going Once, Going Twice, Sold!
Yesterday, Spain auctioned €2.6 billion in two and ten year notes to what appeared to be eager buyers. Notably, the bid to cover ratio -- a measure of how much demand there is for an issue -- improved considerably since the last auction of similar maturities.
Importantly, the 10 year note stayed under the 6% level. This is a critical level according to commentators around the globe which, if breached, will make Spanish debt levels unsustainable.
The first two times the Spanish 10 year jumped above 6%, in July and November of last year, apparently weren’t as critical.
When that level was last breached, the critical level suddenly jumped to 7%. Poof! “Everything is fine, there is another hundred basis points to go before there is any real trouble,” a booming voice said.
The truth is that the level of interest rates is an illusion: They simply don’t matter.
The ECB will find a way to create funding for auctions in troubled European sovereigns. There are the overt measures, like the LTRO (long term refunding operations), as well as more typical measures. And of course there is the IMF, which has been busily raising money for its own “firewall” for Europe.
The interest rate market is heavily manipulated and can easily be made to look as if everything is fine... until Toto does some sniffing around the curtain.
“Pay no attention to the man behind the curtain.”
If Spain were as stable as its sovereign interest rates suggest, then its stock market would not be cratering.
The IBEX 35, comprised of the most liquid stocks on the Spanish market, hit a new 52-week low not long after yesterday’s “successful” auction and closed near those levels. The IBEX 35 is one third financials, and it is the Spanish banks that are telling the real story.
Spanish banks will need to be recapitalized, despite official denials from the Eurozone. They cannot survive in their current structure given the surrounding conditions:
- Bad loans top 8% -- or €144 billion -- which is equivalent to about 10% of Spanish GDP
- Overall lending is dropping at a 3% annual rate
- Housing prices slumped more than 7.2% over the last year
- Housing is down approximately 26% since the 2007 peak
- Spanish banks already own 20% of the nation’s empty houses
The economic situation in Spain is arguably worse than the situation in Greece was two years ago. It took two years of can kicking before tiny Greece needed a bailout, and they haven’t even begun to work out how to recapitalize their banks. Spain and its banking system are much larger and are likely to unravel much more quickly than Greece.
When you pull back the curtain and look at the Spanish stock market and its banking system, it is telling you to buy American.
Specifically, the ultimate flight to quality in jittery markets: US Treasuries.
Now, some regular readers are jumping up and down right now saying, “Just a few weeks ago you said to sell bonds now!” I absolutely did, and you can read that article HERE.
Let me explain...
If you are long bonds as an investment -- meaning, something you intend to hold for several years -- you should use these bond rallies to lighten that exposure. I will stick to my bearish long term outlook on bonds.
But in the short term, over the next few months, bonds are likely to trade fairly well, remaining at least stable if not appreciating. This will be driven by growing (or re-growing) concerns in Europe, specifically in Spain, but also France, Italy, and Greece, all of which will have elections in the next 30 - 45 days. It will be further supported by any perceived cracks in Chinese or US growth.
As a trader, the TLT (iShares 20+ Treasury Fund) or any of its long levered derivatives look interesting from the long side as concerns rise in Europe.
As an investor, I am looking to lighten up on bond holdings with this rally.
The illusion of European stability is rapidly fading, and I plan on looking back thinking, “I am glad I DIDN’T fall for that one.”
Price Shock Trader