Markets to trend with a positive bias
Merkel and Sarkozy to unveil a comprehensive European sovereign and bank rescue package, China buying shares of its banks, Bank of England (BOE) increasing the size of its bond purchase program, European Central Bank (ECB) buying covered bonds and giving twelve month loans and the US Federal Reserve (Fed) commenting that they can do more to pump prime the US economy. All these factors have contributed to a sharp rally from lows across equity, currency and commodity markets while bond yields in the US has gone up sharply on the back of some unwinding of flight to safety trades in US treasuries.
The positive news hitting the markets has taken up equities in the US and Europe by 6% and 10% respectively while the Euro has gained over 2.5% against the USD. US ten year bond yields have gone up by 50bps while Reuters CRB commodity index has gained 5%. All these gains have been over the last few days. Indian equity indices have rallied by over 4% while the Rupee gained by a 1% against the USD, before falling back, on the back of global positive news. The question is will this rally continue or not?
The answer depends on how the global events play out in the near future but as markets are heavily oversold, there will be a tendency to cover shorts at every dip in the market, and this will keep markets from sliding down further. The rally has happened from lows for all markets, equities, currencies and commodities, while bond yields have risen from lows. Markets are basically covering shorts in depressed markets and unwinding long positions is overvalued markets (US treasuries).
The Eurozone rescue package is to be unveiled in the beginning of November 2011, and until then markets will not short the Euro. A stronger Euro is beneficial for risk assets given the short term positive correlation it has with equities, commodities and emerging currencies. China buying shares of its banks is again positive for markets as it improves market sentiments across the globe. China’s sovereign wealth fund, which is buying the shares, has assets of over USD 400 billion and the fund is capable of supporting markets through its purchases. The increase in bond purchase program by 75 billion pounds by the BOE, is positive for the UK economy, which will see higher liquidity in the system. ECB giving cheap funds to banks for twelve months will bolster confidence in European banks while it’s buying of covered bonds (bonds backed by assets) will infuse liquidity in the system. The Fed is replacing short dated securities with long dated ones for USD 400 billion to bring down mortgage yields. The Fed is willing to do more if necessary to support the economy.
The fact that there are many obstacles ahead will keep markets edgy. The Slovekia vote, downgrade of Spanish banks and corporate results are all negatives that the market will have to surmount. The Euro bailout plan depends on Slovakia voting for the plan and given internal politics, Slovekia has voted against the increase in bailout funds. However, there is optimism that the vote will gate passed later this week. S&P and Fitch downgraded top Spanish banks citing weak economic outlook and this downgrade adds to the slew of downgrades seen over the last few days, including Italy sovereign rating and India’s State Bank of India. Downgrades affect sentiment and pull down markets. Corporate results are coming out and Alcoa, the largest Aluminium producer in the US delivering results that were below analyst expectations. The company cited weak economic conditions, particularly in Europe as key risk going forward.
The markets are nervous and are reacting sharply to any kind of positive or negative news. However given that markets have come off from lows and holding on despite negative news of Slovakia, Spanish bank downgrade and Alcoa, there is a good possibility for markets to trend with a positive bias. Indian equities and the Rupee should follow suit in trending higher if there are no major negative surprises in IIP and inflation data.