Where we stand after Friday's U.S. downgrade and the ECB's move to support Spanish and Italian bonds--not out of the woods certainly

08/08/2011 12:00 pm EST

Focus: STOCKS

Jim Jubak

Founder and Editor, JubakPicks.com

The announcement that the European Central Bank will buy Italian and Spanish bonds has done wonders for that debt, but it hasn’t done much to stem the global financial meltdown.

The yield on Italy’s 10-year bond fell to 5.28% and the yield on the Spanish 10-year bond fell to 5.16% today after the central bank announced over the weekend that it would start buying debt from the two countries to calm the bond market.

But global stock markets continued the sell off that began last night in Asia. In Hong Kong the Hang Seng finished down 2.17%, which was the best level of the day. The Shanghai Composite tumbled 3.8%. The index is now down 21% from its peak. Brazil’s Bovespa continued its recent record as the world’s worst performing stock market falling another 5% as of 11 a.m. New York time.

The European stock markets don’t seem to be finding any solace in the European Central Bank decision to intervene. The French CAC 40 Index is down 3.98% and the German DAX Index is down 4.63%. In contrast the Spanish IBEX 35 Index is down only 1.96%.

That may seem illogical but Germany, which fought against this latest intervention, is seen as the biggest loser from the decision. German taxpayers will ultimately have to pick up the bill, it is fear (almost certainly correctly) and that could lead to some combination of higher inflation and slower growth.

Back in the United States, the Dow Jones Industrial Average is down 2.13% and the Standard & Poor’s 500 is down 2.79% as of 11:15 in New York. But it’s hard to tell if that’s a reaction to the continued turmoil in Europe or to Friday’s downgrade of the U.S. credit rating to AA from AAA.

It has helped limit the damage that S&P got caught in a $2 trillion math error on Friday. That gave credibility to the push back by U.S. Treasury against the move. S&P wound up caught on its back foot and having to claim that the $2 trillion error, which the company’s analysts admitted, wasn’t significant to the downgrade since the downgrade was based mostly on the company’s judgment that U.S. politics will make coming up with a credible plan to reduce the deficit just about impossible in the medium term. A credit rating company that’s forced to fall back on its expertise in analyzing politics isn’t arguing from the strongest position.

The key now is how Asian markets, given a chance to digest the European and U.S. news, will react overnight. If they fall further tomorrow, it will be hard for Europe and the United States markets to reverse course.

The reaction of European markets also indicates just how much damage the European Central Bank has inflicted on itself by its equivocation in crisis. Analysts are talking about $1.2 trillion in bond purchases by the European Central Bank. And when that doesn’t put a floor under the financial markets, you know that the markets have serious doubts about leadership in the crisis from the bank.

One final word on emerging markets. By my Jubak 2X rule of thumb a 20% drop in the more volatile emerging stock markets is equal to a 10% correction in developed markets. China and Brazil are now both firmly in that 20% correction zone. I know this is a scary time and the markets seem like they’re sailing in uncharted territory, but China’s markets have a good record of rebounding from 20% drops in August to stage solid rallies.

This time is different—we’ve never been through a U.S. credit rating downgrade. But the performance of emerging markets isn’t exactly unprecedented so far.

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