Risk-off. The sharp collapse of Russian equities in 2008 offered two clear lessons for those perceptive enough to learn: In risky asset classes it is necessary to be able to change your outlook very quickly, and sometimes the risks of locking in losses are less than the risk of staying put. Any investor equipped with these basic – but rare – skills has a chance of doing well in the financial markets.
Quick mood changes were in evidence in the past week. Much remains unclear about President Obama’s plans to change financial sector regulation. But one thing was immediately clear – it would unleash a bout of uncertainty on a market that was already looking fully priced. Against zero interest rates and a Fed in full reflation mode, I would not be so arrogant as to call the top. But, as of Thursday morning I would prefer to sit out the equity market, for a while at least. A 50% leap in the Vix speaks of further selling ahead.

Not that I seek to blame exogenous causes. Dino is right, the problems are structural and the events of last week barely affect the fundamental circumstance. But, they do affect sentiment.

After months of ignoring the risks, the market now has a genuine set of excuses for selling off: Not China, where I would argue that the government is well on top of cooling the market, and has ample means to manage asset prices. But, euro risk (Greece) and financial services regulation are enough to bring on a well deserved bout of cooling. How far it goes remains to be seen. (But technical indicators, such as moving averages are as good a guide as any in such circumstances.)

The S&P 500 lost 3.9% last week, closing at its lows and showing every sign of charging through resistance levels in the coming sessions. Emerging market equities lost 4.6%. US treasuries gained modestly – the silver lining of equity selling at this time is that it may alleviate some of the pressure on bond prices. Gold too sold off, and looks precariously poised for further selling, which will create an exceptional buying opportunity for those patient enough to have avoided last year’s rally.

The dollar also benefited, rising 1.2% against its core basket, although this was mostly a function of euro weakness, as investors continued to notice the risks in peripheral economies, primarily Greece, where default risks have soared.

Chart 2: Greek Vs German 10yr

The eurozone has been set for a shake-out for sometime. Without missing the structural issues and economic malaise, Market Melange believes the outright risks of a Greek default are low. And I would go so far as to suggest that Greek bonds are beginning to look interesting (Chart 2). The inversion of the Greek CDS was a curious reversal of risk perception, and at 304bps over the German 10 year, Greece’s long-end debt is now cheaper than many of its Eastern European peers, a dynamic that hasn’t been seen for several years.

After breaking its 200 day moving average against the dollar, the euro remains a firm sell (Chart 3), but after rising almost 200bp in two months, the downside for Greek debt is a less clear call.

Chart 3: EUR/USD & 200-Day Moving Average

Where to next then? This week we get our first look at 4Q09 GDP and the Fed will meet. Durable goods, consumer indicators and a surge in 4Q earnings pack out what will prove a busy week.

Realistically, considering its accuracy, the first glance at 4Q GDP ought to be irrelevant (consensus outlook is arguably as accurate as the first glance number ultimately proves to be). But animal spirits rule the short-term, so this report has a chance of cooling or inflaming the mood either way (expectations are ambitious at 4.6%).

The Fed meeting matters too. Minutes from December showed just how uncertain the FOMC is about whether or not to proceed with ending QE. My call for this week is that it will again reaffirm the intention of stopping QE on schedule (the 30 year mortgage rate continues to decline at this time). But, it will also express readiness to reverse that decision if necessary – an event of at least balanced probability.

Stay on your toes then, things could still go either way, but the probability of excellent entry positions emerging is now higher than it has been for months. Here are some of the key data points we are watching this week:

Monday
Europe – Mauldin In Monaco. Renowned financial market commentator John Mauldin speaks at IUM in Monaco.
US – Existing Home Sales. The market expects home-sales to have picked up MoM.

Tuesday
Europe – Current Account. Expected in deficit, a short-term event unlikely to noticeably impact EURUSD.
US – Case-Schiller House Prices (Nov), Consumer Confidence (Jan). After sharp falls in Oct, Nov house prices have the scope to challenge bullish sentiment on the housing recovery. Consumer confidence is expected to have improved, if GDP expectations are accurate this is not surprising.

Wednesday
US – New Home Sales (Dec), FOMC. New home sales may increase MoM, but the market will be waiting on that FOMC statement all day.

Thursday
Europe – Consumer Confidence (Jan). Still weak.
US – Durable Goods (Dec). Continued improvement in durable goods has not yet reversed the YoY declines.

Friday
Europe – Unemployment Rate (Dec). Unlikely to have fallen below 10%.
US – 4Q GDP, Consumer Sentiment (Jan), Chicago PMI (Jan). The expectations for GDP are strong, predominantly on inventory shifts (which have to show up sometime!) January data are expected mixed.