Return of Son of Bounce

06/10/2010 1:33 pm EST


Jim Jubak

Founder and Editor,

You can tell a lot about now oversold a market is by how much it takes to create a bounce.

The explanations for today’s rally that I’m seeing cite the big surge in Chinese exports (For more on that news, see my post ) and the good news out of Europe.

That’s not much to build a rally on. Especially because the news out of Europe isn’t so much good as “not too bad.”

To me the extent—global—and degree—2% on the Standard & Poor’s 500 and on the Dow Jones industrial Average as of 1:30 ET—of the rally indicate that financial markets were so deeply oversold that they were ready to bounce on even weak good news.

And that makes them especially vulnerable on the downside to any bad news—from, say, weak U.S. retail sales numbers tomorrow. (For more on the risk in those numbers see my post )

The “not so bad” news from Europe that’s helping feed this bounce?

First, Jean-Claude Trichet, the head of the European Central Bank, said this morning that the bank will extend its offerings of unlimited cash of European Union banks and keep buying government bonds.

In other words, things are still so bad that the central bank is going to keep those emergency provisions in place to head off a descent into something even worse.

Oh, and the bank announced that it will keep its benchmark interest rate at 1%.

Second, Euro Zone governments avoided a complete train wreck and reached agreement to set up a $526 billion European Financial Stability Fund. The fund, part of the $1 trillion rescue package announced weeks ago, has been “funded” with guarantees from its Euro Zone governments. That will give the fund the ability to lend directly to governments that have been shut out of the financial markets because of their budget problems.

You know how little confidence the financial markets have in Europe’s political leaders when agreement on something that should have been certain to pass and where failure to agree carried clear disastrous consequences is greeted with a continent-wide cheer.

The cheers are likely to get a little less loud when investors get a chance to read the fine print.

The Stability Fund won’t lend until a country can’t sell its bonds at a yield of less than 5% or so. So far only Greece is in that sinking boat but Portugal isn’t far behind after yesterday’s bond sale. The fund will charge about 5% for its loans. (Greece currently pays 5.2% for loans of longer than three years under another $133 billion program.) In other words this isn’t cheap money and interest rates like these will make it harder for countries like Greece and Portugal to reduce their budget deficits without sending their economies into recession.

Another wrinkle: when a country has to turn to the fund for help, it can no longer act as part of the group providing guarantees to the fund. That’s an absolute necessity if the Stability Fund is to get the kind of AAA credit rating it needs to act as a backstop to individual governments at a reasonable cost.

But that also means that each country that has to drop out of the fund’s pool of guarantors reduces the funds lending capacity. The fund has been set up with guarantees from member governments equal to 120% of its $526 billion lending cap. If Portugal, Spain, and Ireland all turned to the fund to borrow that would wipe out the 20% cushion at the fund. Any requests beyond that would cause the fund’s lending capacity to sink extremely rapidly.

But those are all problems for another day.

Tomorrow perhaps.
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