The Overnight Report: Reality Check

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By Greg Peel

The Dow fell 187 points or 2.1% while the S&P fell 2.4% to 923 and the Nasdaq lost 2.3%.

I suggested yesterday in The Week Ahead that Wall Street needed confirmation of the economy catching up with the share market for the share market to push further ahead, but that sidelined cash was still ready to buy the dips. Last night’s trading supported the former but the buyers had the day off. There were, however, extenuating circumstances.

Everything that was to affect Wall Street last night was mostly known before the opening bell, such that the Dow opened down around 200-odd points lower and then went dead sideways for the rest of the session. It was more of an orderly recalibration than a selling frenzy and no late buying materialised as has been the case often in recent weeks. It is assumed the buyers are a little wary of President Obama’s new policies on regulatory reform, which are now slated to be announced on Wednesday. Volume on the day was subsequently extremely light.

The proposed reform agenda was outlined in the Wall Street Journal last night but contained no great surprise. The Administration wants to grant the Fed more powers to oversee mega-banks in order to control systematic risk. A body will be set up to oversee consumer-based financial products (think subprime mortgages). Higher levels of bank tier one capital will be required. There will be stricter standards for the issue of asset-backed securities (think CDOs) and originators will be required to maintain a financial interest in what they issue, rather than simply passing off risk. Finally, an “extraordinary circumstance” power will be granted to dissolve companies which have become too big to fail.

None of this is a shock, but the market would still like to hear confirmation on Wednesday. If no other nasty rabbits are pulled out of the hat on the day, the market should see that as a positive, all things being equal.

But the negative news last night was simply economic. Last month Wall Street surged when the National Association of Home Builders sentiment index shot up for the month. This month the index has fallen by one point to 15, marking the first decline since January when the index bottomed at 8 points. While not devastating, it does indicate sentiment may have become overblown. At its peak four years ago, the index reached 72.

Wall Street has become used to indicators becoming less negative, and perhaps thus complacent, but last night the Empire State (NY) manufacturing index fell to negative 9.4 from a negative 4.6 in May.

Weak economic data were never going to be good news for soaring commodity prices, and thus a correction was on the cards. But when weak data coincided with a big bounce in the US dollar on the session, the dam broke.

The US dollar index jumped over 1% to 81.08 last night due to a number of factors. Ironically, economic weakness and fear tend to trigger a rush back into safe havens such as short-end US Treasuries, which thus supports the dollar. Higher risk trades such as carry trades and emerging market investment are also reversed in the greenback’s favour. Bond yields fell in the US overnight.

The long-term Treasury flows data showed US$58bn was extracted by foreigners in April, which is also cause for concern, but support for the greenback came out of the G8 meeting of finance ministers held on the weekend. Russia has recently been vocal about investing in IMF bonds instead of US bonds and in supporting a move away from the greenback as reserve currency. However Russia’s finance minister suggested at the meeting there was no “near-term alternative” to the dollar. The BRIC’s have to tread lightly on the reserve currency issue for fear of setting off US dollar selling which would undermine their existing investments.

Given the US dollar outflows in April, the market might be advised to watch what the BRICs are doing rather than saying.

The US dollar was also boosted because the euro was weak after comments from the ECB suggested there was no room for complacency in the European financial system and that risks still remained high. Banks in particular need to ensure they have sufficient capital to weather ongoing storms, the ECB suggested. Just like the US data, these comments rather took the wind out of some of the optimists’ sails.

So there was never going to be any other result than a commodity sell-off last night. Oil fell US$1.79 or 2.5% to US$70.25/bbl. Aluminium fell 2% in London, tin 3%, copper 4%, nickel 5%, and lead and zinc 6%. Copper just managed to hold above the psychological US$5000/t level. In US trading, BHP Billiton ((BHP)) was down 4% and Rio Tinto ((RIO)) 6%.

While fear may have again been heightened, gold lost out to the jump in the US dollar, falling US$11.00 to US$928.00/oz. Silver fell 5%. The Aussie was trashed by close to two cents, marking US$0.7949.

The VIX volatility index jumped back over 30. Friday is “quadruple witching” on Wall Street, on which stock options, index options, futures and futures options all expire. This quarterly event usually leads to a big build up in volume in the preceding week as option traders jostle to push values above or below strike prices. With Wall Street waiting for Obama’s speech on Wednesday, there may yet be a lot of high volume volatility later in the week.

The SPI Overnight fell 58 points or 1.4%. This implies a drop below the 4000 mark in the ASX 200 on the open today.

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