From Risk Aversion to Risk Conversion:
There was little doubt yesterday in (most) capital markets as to how Europe's recovery plan was received. In brief, there was an overwhelmingly positive response to the plan that appeared to have the right ingredients, but was yet still lacking key details.
The S&P 500 spiked 3.4% in a power surge led by the financial sector (+6.2%), Treasuries got clobbered, commodities rallied, and the dollar took a dive as the risk aversion trade turned into a risk conversion trade.
Safe-haven plays were discarded, or at least underperformed, while risk assets caught a persistent bid.
The scope of the move suggested it was a catch-up rally as underinvested participants redeployed sidelined cash in an effort to catch up to performance benchmarks and out of concern that they could miss out on further gains. With a number of pundits previously suggesting the market would be disappointed by a plan that lacked specific details, we suspect there was a wave of short covering as well that augmented the day's gains.
If there was a fly in the ointment, it was European bond markets, and particularly Italy's bond market, which ultimately retraced a significant portion of earlier gains that saw the yield on its 10-year bond slip to 5.60%. Today, that yield is back at 5.93% following a 10-year note auction that went off at a euro-era record yield of 6.06%.
There has been a good bit of consternation over Italy and its commitment to implementing reforms that are necessary to reduce credit risk. Additionally, questions remain as to whether the EU rescue plan will ultimately have enough firepower to deal with a run on Italy's bond market, were one to occur.
The Italian government has indicated that it will present a reform plan with specific details by November 15. In the meantime, the behavior of its bond market will be closely watched by participants as a risk gauge.
There are reports this morning that the weak bond auction in Italy is pressuring the futures market. Currently, the S&P futures are down seven points and are trading 0.4% below fair value.
We are going to reserve judgment there. After the rally we had yesterday, and over the last three weeks, it is easy to pinpoint thoughts that sound reasonable for explaining market setbacks without acknowledging the simple thought that the weakness could simply be a case of profit taking after such a strong run.
Our suspicion is that pullbacks in the near term will be looked at as a buying opportunity by participants still playing catch up here and who are banking on a month-end move with a bullish bias and the transition to what has historically been a bullish period for the equity market (November to April).
Each year is different of course, so there are no guarantees on history repeating itself. The tide of sentiment has certainly turned more bullish in recent weeks, but developments on the follow through in implementing the EFSF, as well as the efforts by the "Super Committee" in the U.S. Congress to agree to a deficit reduction plan by November 23, are expected to keep things interesting from a trading standpoint as we roll through November.
For now, this October is on track to be one of the best months in market history, meaning it has been very scary for short sellers as Halloween draws near.
Separately, the Personal Income and Spending report for September didn't reveal any major surprises for the market. Income increased 0.1% (Briefing.com consensus +0.3%) while spending jumped 0.6%, as expected. With this data incorporated in yesterday's Q3 GDP report, the response to it has been fairly muted.
Take time to look around, even on a down day!
