On Monday’s morning note, I commented that “Bulls remain on parade, and the much anticipated pullback that many expect hasn't happened. At this point, it is starting to feel like a pullback might not happen for some time.” What a difference a day makes. Equity markets across the globe got pummeled yesterday after S&P downgraded Greek sovereign debt to junk, while also downgrading Portugal’s sovereign debt rating one notch. These downgrades strengthened fears that a sovereign debt crisis is officially spreading throughout the Euro zone. Coupled with the embarrassment that was the Goldman Sachs Senate testimonies yesterday, we finally had the perfect storm in place to commence a pullback. The question going forward is whether or not this is truly the start of a market correction, or just a one day blip that will ignite buying. Interestingly, the Dow closed below the 11000 level (10991.99) for the first time since breaching that threshold on April 9th. From a psychological and technical perspective, it will be critical to get back above 11000 to avoid the correction. Futures are pointing to a slightly stronger opening, so the early read is that buyers are standing by.
Getting back to the Greece situation, I have stated before that I believe the Euro as a currency is doomed over the long-term. This is the first crisis the Euro nations have faced and they have choked on it. Inevitably I do believe the contagion will spread to other member nations and that they too will require a bailout. Most notably, Portugal, Ireland, Italy, and Spain have similar issues to Greece, and together they are now well known as the PIIGS. The hope is that this doesn’t evolve from a European sovereign debt crisis into a European bank crisis. Tangentially, the weakness of the Euro has been a godsend for the U.S. dollar as it continues to strengthen on the flight to quality trade. This is excellent news for the U.S. as a stronger dollar is anti-inflationary. This certainly buttresses the Fed’s decision to maintain extraordinarily low rates for an extended period. If the dollar can maintain its strength, which is increasingly probable given the Euro situation, inflation expectations could remain anchored for some time, allowing the Fed to stay on hold until it is confident the U.S. recovery is sustainable. In turn, this could keep interest rates across the curve in a range bound environment for longer than most people think.
In regards to the Fed, the FOMC will be announcing its rate decision around 2:15 pm et today. While nobody expects the Fed to raise the fed funds rate, it is a possibility that they could raise the discount rate. Some do expect a slight modification to the language, but I don’t’ believe that will happen. I believe they will reiterate their desire to keep rates low for an extended period, which puts any rate increase out at least another six months. More importantly, it is being speculated that the Fed is going to highlight its plans on how they will reduce the size of its balance sheet (i.e. selling $1.25 trillion mbs) without disrupting the markets. Stay tuned this afternoon!
On the treasury front, yields move markedly lower across the curve yesterday on the flight to quality trade. The 2-year treasury touched .94 basis points prior to a sloppy $44 billion 2-year auction yesterday, which caused treasury yields to move higher off the lows of the day. Yields are slightly higher this morning as the treasury is set to auction $42 billion in 5-year notes. The rally in treasuries got a little ahead of itself yesterday so a slight back-up in rates is not a surprise.
On the fixed income front, without sounding like a broken record, it is important to remain flexible and opportunistic. Days like yesterday provide a great opportunity to sell, while pullbacks provide a nice opportunity to put cash to work. Switching sectors can also pay dividends when spread relationships change.