The Overnight Report: Compromise Reached At The G-Whiz

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By Greg Peel

The Dow closed up 216 points or 2.8% while the S&P added 2.9% and the Nasdaq 3.3%.

The Dow closed at 7978, eclipsing the previous rally-high close on March 26 of 7924 and the intraday high of 7969. But last night the Dow reached 8075 at its peak (up 314) before the late sellers took over.

The previous high on the more relevant S&P 500, however, was 832 for both the close and intraday on March 26. The S&P reached as high as 845 last night but traders were keen to see whether the index could close anywhere above that 832 level, as that would represent a break above the 100-day moving average – a bullish sign. It closed at 834.

It was nothing if not an interesting rally last night. The Dow shot up a couple of hundred points from the bell, indicating that this was not a gradual rally but more of an adjustment to the FASB news. The extra hundred points later gathered came as Wall Street liked what was coming out of the G20 meeting in London, and the late sell-off – while typical – again showed that 8000 is still a formidable barrier.

The Financial Accounting Standards Board last night did what Wall Street had expected and relaxed the mark-to-market rules for “distressed and inactive” securities, allowing a return to “mark-to-model” based on what individual holders consider to be a fair net present value calculation. While mark-to-model was once dubbed “mark-to-myth” by a frustrated Wall Street, this time FASB will supposedly scrutinise valuations more closely and require “marks” to be justified every quarter, instead of every year as was the case prior to 2008.

The Board voted unanimously to relax the rules, appreciating that forced mark-downs had caused forced write-downs of bank profits and major balance sheet erosion. This has long been the argument from the critics of mark-to-market. However the critics of mark-to-model suggest that banks can now reduce transparency on their balance sheets, which is just a return to the bad old days.

On the matter of “write-ups” – banks declaring a profit by writing back that which they have written down previously – there was some confusion. The Board was split but allowed this measure on a 3-2 vote. But Citigroup immediately came out with a statement saying the change of rules will have “no impact on Citigroup’s financial statements or our existing practices for determining fair value”. This implies Citi will not be declaring any profit in Q1 specifically on an accounting adjustment. We will have to now wait and see how other banks respond.

I suggested yesterday that a successful FASB outcome might spark a “sell the fact” given the S&P Bank index had risen 50% already in anticipation. As it was, the Bank Index shot up 9% on the open but was immediately sold down, reaching as low as only 2.5% up on the day before closing up 4% on the Day. This prompted traders to remark that while the bank stocks may have sparked last night’s rally, they didn’t really participate, and that’s unusual.

But what the FASB appears to have really fuelled is a growing “get me in” trade, as sidelined investors start to panic that perhaps the bottom really has been seen and they’re going to miss out on the next bull run. This pressure then sparks further short covering from those who had already sold into the rally, and what you get is these sharp 300 point moves.

The other early news on Wall Street came from across the pond. It was EU rate decision day and the market had assumed the ECB would cut its cash rate from 1.5% to 1.0%. The ECB instead cut by only 25 basis points to 1.25% thus sparking a rally in the euro, or a fall in the US dollar. The argument from the ECB is that lending rates in the EU are being priced off the ECB’s deposit rate, rather than its lending (cash) rate, and the deposit rate is now effectively zero.

The US dollar thus fell against the euro, pound and Swissy, but rose against the yen. Yen selling implies a return to risk appetite, which is become the case since stock markets have begun to rally again. A weaker dollar index and a weaker yen are both fuel for the Aussie. The Aussie already shot up yesterday in local trade on the unexpected trade surplus result, but finished up almost two cents over 24 hours at US$0.7155.

The weaker US dollar once again fuelled the “reflation trade”, which simply implies that dollar-denominated commodity prices must rise if the dollar falls. Thus despite more weak physical data, oil jumped 8.5% or US$4.07 to US$52.46/bbl.

Base metal prices similarly went for a run in London. Zinc only managed a 1% rise and copper- which has led the pack this last month – rose 2%, albeit to a new five-month high. Aluminium, lead, nickel and tin nevertheless all rose 3-5%.

The result was a bit of a chicken and egg rally in the Wall Street materials sector. Commodity prices were stronger on the back of the dollar which pushed up the materials index, which pushed up the overall index, which encouraged more commodity buying on the “economic recovery” a stronger stock market is supposedly foreseeing. Given the rally is devoid of any actual increase in physical demand for commodities, it could all end in tears, although there is a growing belief on Wall Street that while there may yet be another down-leg the bottom has definitely now been seen.

Last night BHP Billiton ((BHP)) added 8.3% in New York trade.

The other event providing Wall Street with some stimulus last night was the G20. No one held out much hope for anything material coming out of the G20 meeting, in the form of action rather than talk, because (a) it never has before and (b) the world has been split between the reflators (US, UK) on one side and the regulators (Germany, France) on the other. But as it was, a compromise was reached.

Detail was not forthcoming, but basically the world agreed to pump another US$1 trillion into the IMF to provide aid to struggling economies and to reinvigorate global trade. Call the latter a collective stance against protectionism. At the same time, it agreed to clamp down on hedge funds, tax havens and executive pay – hence the compromise.

Fearing that the reflation trade may have hit a wall before the G20 meeting even began, Wall Street was heartened by the outcome. The world is at least throwing some collective money at trying to stimulate the global economy, and that should be good for shares.

The danger is, nevertheless, that paper currencies are further undermined. While protectionism can work by blocking trade, it can also work by devaluing one’s currency to make one’s exports cheaper. This is one area where Germany and France have been critical of the UK and US, both of whom have implemented quantitative easing. But last night the G20 members vowed not to individually attempt to devalue their currencies at the expense of others, lest they draw global wrath. As to how global wrath is manifested is not clear, but it sounds pretty scary.

The upshot of all of the above is that despite a fall in the US dollar, it was not a good night for gold. The G20 leaders also endorsed the IMF request (from last year) to sell 403t of gold to help finance its greater obligations. This is not new news, and the gold will be eked out slowly, but it does offset the inflation effect of another trillion being printed for the IMF. At the same time, gold is battling against the re-emergence of risk appetite, which makes the safe haven no longer necessary for some. Thus last night gold fell US$23.20 to US$903.20/oz.

This is rather heartbreaking for holders of Aussie gold, as they lost on both the US dollar gold price and on the Aussie.

Despite a very big move up in the local market yesterday, encouraged along by the trade surplus number, the SPI Overnight was up 56 points or 1.5%.

The trade surplus is interesting, given (a) exports of bulk minerals (iron ore, coal) are still working off 2008 prices until 2009 prices are negotiated down shortly, and (b), imports crashed to make exports look even better, which is simply a sign of recession.

Another interesting point to note is that despite all the fresh euphoria – the stock buying, yen selling and gold selling – the S&P 500 VIX volatility index still can’t seem to break under 40. This means there are still plenty of traders out there buying put protection into this rally.

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