@ the open 2-22-12

Equity Markets – Asian markets were mostly higher in overnight trading but the late closing markets were negatively impacted by the news out of the EU that the purchasing managers index was unexpectedly below 50.0 some widening in peripheral bonds ensued and the realization set in that while there was an agreement by the finance ministers over the “Greece II” bailout, the bond exchange has yet to take place and expectations remain that this is a “bridge too far” for Greece to ultimately cross and the 2nd bailout is no panacea for what ails the EMU. European indices are at or near their lows for the session and US futures are following suit. I continue to like the long volatility trade here but would implement the VXZ trade rather than the VXX trade and here’s my logic:

• 2nd LTRO is coming and the ECB will once again flood the bank market in Europe with liquidity…this could serve to dampen short term volatility while ramping up expectations for future volatility when the LTRO is taken off the table. Result - + for VXZ which utilizes longer dated futures mix / - for VXX which sticks to the shortest term contracts and thus suffers if contango increases as a result of expectations that volatility will rise in coming months.
• EMU has committed to the Greek 2nd bailout so its going to happen but there will likely be growing concerns in coming months that it wasn’t enough as the Greek economy continues to struggle and the EU “force in Athens” will focus on “solvency” not “ deficits” but the Greeks will need monies to plug their growing deficits. Result – again growing volatility in the “out” months hence + for VXZ and – for VXX.

I’m certain that you can come up with more examples of future uncertainty that will ramp future volatility and benefit VXZ while potentially harming VXX (Chinese GDP growth estimates, risks to the Japanese recovery scenario, elections in France and Greece, Iranian / Israeli conflict…pick it).

Macro, News & Events

Economic releases

• Weekly MBA mortgage applications…last week’s reading was -1.0%
• January Existing home sales (SAAR)…4.66 mm v. 4.61 mm
• January Existing home sales (MoM)…+1.1% v. +5.0%

Events

0930 – USEEOC will hold a meeting today which is open to the public (131 M Street)
1230 – World Bank President Zoellick will speak at Cambridge (1730 GMT) on “Military History and the World Bank” a somewhat ominous subject matter given current events
1530 – Treasury Undersecretary for International Affairs will hold a press briefing prior to Secretary Geithner’s trip to Mexico City for the G-20 finance chiefs’ meeting this weekend

Earnings – as of the end of day yesterday, 80% of the S&P 500 companies have reported the calendar Q4 earnings…to date, the average annual growth rate in EPS for the quarter is +5.04% with an average positive surprise of +3.15%. Today we get numbers from another 15 companies…most interesting (my opinion) are : Fluor (engineering & construction); Williams (natural gas pipeline); Washington Post (media); Winstream (rural telecom); Quanta (contract services) and Dollar Tree (retail).

Asia, Europe & USA

• Chinese manufacturing may decline for a 4th consecutive month in February according to the preliminary manufacturing index put out by HSBC…the projection is for a reading of 49.7 following the official 48.8 reading from January (any index value below 50.0 denotes contraction). The PBoC cut the reserve requirement ratio (RRR) by 0.5% in an attempt to stimulate loan growth without trying to drive inflation. Expectations are that growth could slow to 7.5% this quarter and while that would be stellar growth by OECD standards that’s a slowdown by Chinese standards.
• The manufacturing and services index for the EU came in at 49.7, below the consensus estimate of 50.5 and signaled that the EU manufacturing sector as a whole is still grappling with the ongoing effects of the debt crisis and consequent austerity moves.
• German paper is higher in price on the day as the government will auction €5 billion of two year notes…meanwhile Portuguese spreads widened by 39 bps and Italy widened by 8 bps as ongoing uncertainty with regards to the Greek bailout effectiveness and the ultimate resolution to the crisis remain in the distance
• PSA and GM are reportedly in discussions that could create an alliance in Europe of their combined operations…
• The IAEA said that Iranian authorities denied its inspectors access to a suspected nuclear-related military base

Credit Markets –

Sovereign CDS – spreads are modestly wider this morning as the EU purchasing manager’s index unexpectedly declined signaling that the EU economy isn’t out of the woods yet…the SOVX for Western Europe remains above +330 bps.

Overnight – the euro / dollar overnight index swap spread differential has declined to less than 29 basis points as the LTRO (long term refinance operation) put in place by the ECB has flooded the European banking sector with liquidity and the next “auction” is slated for next Tuesday.

US Corporate Credit – the credit index swap market was little changed yesterday with investment grade outperforming lower rated credits…the IG index was tighter by 1 bps (+98 bps) while the high yield index was unchanged (+570 bps) and the leveraged loan index widened by 4 bps (+350 bps). Yields on the 5-year US treasury note closed at 0.902% yesterday down fractionally from 0.908%...the 10-yr treasury note was down ½ basis point in yield to 2.055% as we continue the roller-coaster ride on the 10 year yield between 2.1% and 1.8%...

Energy Markets – oil prices continue to ratchet higher as demand from the emerging markets combines with growing tensions from the Persian Gulf to push energy prices higher. The WTI / Brent spread is down to $15.39 this morning, down from almost $19 / barrel in the last two weeks. Short of a coherent change in energy policy here in the US designed to take advantage of the ocean of natural gas that has resulted from horizontal drilling and hydraulic fracturing recovery methods the US will continue to be subject to international oil market volatility.

Futures – the futures curves continue to press higher although in somewhat different directions…the natural gas futures “strip” continues to steepen as we go out a year but the oil market futures currently peak in late summer before rolling over indicating that there remain doubts about continuing growth in demand out beyond the summer driving season and that perhaps, the market thinks that some energy policy changes here at home could be forthcoming by the summer. The equivalence ratio remains above 5.6x

Phillip Pennell, CFA
Turnberry Capital Management
(203) 861-2708 (Direct)
(203) 861-2700 (Trading)
(203) 917-2255 (Mobile)

The information included in the above discussion is not intended to be used as a basis for making investment decisions nor should it be construed as a recommendation by the author to buy or sell any specific security. Individuals should consult their investment advisor prior to making any investment decisions.