The sleeping lion awakens
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In This Issue...

*Enter volatility...
*It's all about the euro debt... 
*Gold and silver knockdown... 
*China and Japan chat...

And, Now, Today's Pfennig For Your Thoughts!

The sleeping lion awakens

Good day.and welcome to the last Thursday of 2011. The markets have been in a slumber since last Friday, but that all changed yesterday when the sleeping lion, i.e. volatility, decided to rise and take a stroll around the terrain. We began the day as any other with not much to speak of during the Asian and European trading sessions, but traders in the US markets had a much different idea. There's a lot to talk about so let's jump right in.

As you can see from yesterday's currency round up, most currencies and metals were still wearing the same clothes from the previous night. When I fired up the currency screens yesterday, the euro was in a tight range trading around 1.3070 with gold hovering around $1590 and silver right around $28.60. I was getting a little worried as to what I would talk about today since it looked as though Wednesday was going to be another blow off day in the news department. It didn't take long for that to change.

As soon as 8:30 rolled around, the wheels immediately fell from the wagon and everything dropped like a rock and didn't look back at all. The US markets were definitely risk averse as the euro promptly fell by over 0.50% and gold sold off by $10. It didn't stop there. After just an hour into the trading session, and maybe about the time that second cup of coffee was being poured, silver was already down $1.00, gold was down nearly $20, and the euro was trading into the 1.29 handle.

I'm sure you're asking yourself what in the wide world of sports caused such a stir when no data was released in the US, or any other major economy for that matter, and the absence of any damaging news headlines that would have sent investors running to the hills. Well, a lot of it had to do with a thin trading market but if we had to nail it to one item, it was renewed fears about the European debt crisis. This topic is going to continue to be a thorn in the side of all financial markets until uncertainty subsides. There are some big question marks that remain, as I touched on yesterday, and the markets aren't particularly fond of uncertainty.

Things were looking decent on the day as the Italian bond auction of six month Treasury bills, which some were concerned with on Tuesday, ended up with a successful outcome. Italy sold 9 billion euros of 179 day bills at a demand of 1.7 times, which means there was more demand than what was actually available, and eclipsed the previous demand rate of 1.47 times. Another bit of good news that occurred had to do with the yield. In fact, the yield dropped to 3.251% from the 6.504% that resulted in the previous auction on November 25.

The reason traders have been making a big deal about a rising or falling yield has to do with the ability of the issuer, in this case Italy, to pay out the principal or interest and avoid default. If yields rise to the point that the capital needed to repay the debt obligation, as a result of higher interest payments, there may not be enough to pay principal or vice versa. Since Italy can't print more euros to avoid default, investors can demand higher yields for the higher risk. The US doesn't have that problem, in theory, since the Fed can just run the printing press, but the euro countries don't have that luxury.

The shorter maturities aren't really the concern. We will have the longer maturities auctioned today and will be a good test to see where things actually stand. The all important 10 year bond is approaching the point of concern. In fact, yields of at least 7% in Greece, Ireland, and Portugal all foreshadowed subsequent bailouts so the previous Italian yields pressing above 7% sparked speculation of a possible bailout at some point going forward.

The other bit of concern surrounded the size of the ECB's record high balance sheet as it rose to 2.73 trillion euros ($3.55 trillion) after it lent financial institutions more money. They decided earlier in the month to offer banks unlimited cash, or loans, for three years in an attempt to ensure enhanced access of the banking sector to liquidity. 523 banks were awarded a record 489 billion euros to encourage lending, but so far, they are just parking the money. Sounds pretty familiar, doesn't it.

We're seeing the same thing that happened here in the US, in that, banks are taking these loans but not exactly using the money for its intended purpose. These European banks are just sitting on the cash instead of lending it out in order to keep credit flowing in somewhat of a functional manner. If banks continue stockpiling capital in an effort to shore their own balance sheets, we could see the credit markets feel pressure once again and was some of the fear floating around the markets yesterday. Both events weren't exactly new revelations, but these thin markets can be swayed easily.

Talk about a rough day. Gold and silver took the brunt of the sell happy market yesterday as they both lost about 2.5% and 5.5% respectively. By the time I left the office last night, gold was hovering around $1550 and silver was trying to stay above $27. In fact, silver traded as low as $26.86 on the day and except for the sharp drop in September, we haven't seen these levels since January. I looked at a one year chart for silver and the volatility has been unbelievable, taking into consideration we've seen a high in April of $49.79 and a low of $26.07 back in September.

Aside from the overall risk aversion, gold had some additional pressures that pushed it down nearly $40 on the day. Fundamentals are definitely not in play and haven't been for quite a while as economic worries would normally push gold prices higher. The stronger dollar had a hand in the cookie jar but news that gold imports from India, the world's largest gold jewelry consumer, could fall as much as 50% this month since the rupee has dropped quite a bit against the dollar. Commodities, in general, are priced in US dollars so a weak rupee and a stronger dollar looks to be enough to hamper demand.

I also saw a report that China restricted gold trading in the spot and futures market, the Shanghai Gold Exchange and the Shanghai Futures Exchange, to crack down on illegal buying and selling of commodities in that nation. Since there was evidence of lower demand in two of the world's largest markets, prices consequently fell. If you throw in a thin market and the selling of gold to cover losses in other investments, you get this type of scenario. Gold should end the year in positive territory, as is currently sits on a year to date return of 8%, but we could see more pressure through the end of the year as investors try to lock in gains.

Since there weren't any damaging economic reports released abroad, the foreign exchange market took a hit as a result of risk aversion and flight into the US dollar. All of the non-euro European currencies finished the day with losses of around 1% while the high yielders and commodity currencies saw losses in the neighborhood of 0.50%. The global economic report pipeline is pretty barren for the rest of the week so risk tolerance in either direction should set the trading tone in these final days of the year.

Taking a brief look at Switzerland, we did have a couple minor reports that included a gauge of consumption and leading indicators for December. Both of these reports pointed toward a continued slowdown for the Swiss economy as leading indicators fell to the lowest since August 2009. The Swiss National Bank also lowered their growth projections for 2012 down to 0.50% from 0.90% and said they will enforce the exchange rate ceiling of 1.20 vs. the euro with the utmost determination. Switzerland is still trying to overcome the franc's rise of nearly 37% against the euro in the 12 months before the ceiling was introduced in September.

When I came in this morning, the dollar was adding to its gains from yesterday as most currencies along with metals continue on their downward trek. We did have a bit of positive news from the Italian bond auction as the average yield of 10 years dropped to 6.98%, down from the previous 7.56% yields. A measure of Italian business confidence fell to the lowest level in 2 years so the negative vibe surrounding Europe is still present. The euro has lost the 1.29 handle and is trading at levels we haven't seen since September 2010, while gold tries to stay above $1500 and silver tries to remain above $26. Let's see if the US economic reports due this morning can offset some of these European woes.

As a pseudo then there was this, Chuck sent me a link to an interesting article that appeared in the New York Times earlier in the week, which he promptly coined as "all in all, it's just another brick in the wall." You can click on the link to see the whole story,, but it discusses an agreement between China and Japan to directly trade their currencies in an attempt to move away from using US dollars. While a timetable has not been agreed upon as of yet and specific details such as volumes and other nuances haven't been worked out, this is still another strike for the long term future of the US dollar as the reserve currency.

As Chuck has mentioned many times in the past, the Chinese still have a lot to do before the renminbi can become a viable replacement choice for the world's reserve since it's not a fully convertible currency. I think Professor Kupchan of Georgetown phrased it well in an interview by saying the currency pact is more symbolic than significant right now for the United States. It hardly unseats the dollar as the world's dominant currency but it's a clear sign that China is headed in the direction of internationalizing the renminbi. In addition to another chip in the armor for the USD as the world's reserve currency, this agreement would reduce the need for these countries to invest in USD.

If this agreement does materialize into any type of significant event, we definitely need to be concerned with how our debt would be financed going forward. China and Japan are the two largest foreign holders of US debt so if they don't have a need to hold as many US dollars or purchase US Treasuries, that would certainly present problems as we currently depend on them to meet our debt obligations. While the dollar would weaken if there was less demand, any broad reduction in holdings from China and Japan would result in some very large shoes to fill. We had several readers forward this article as well and wanted to get our thoughts, so there you go.

Recap.Volatility during US trading hours sent most asset classes into the red. As the financial markets are still dealing with thinner volume, renewed concern over the European debt crisis steered the ship. Fears of a lackluster bond offering in Italy, which turns into future fears of a bailout, and the record high amount of debt on the ECB's balance sheet caused widespread risk aversion. Gold and silver took the brunt of selling pressures and thoughts of lower demand for gold out of China and India just perpetuated the situation. Switzerland stands ready to defend its currency ceiling and talks of a currency swap agreement between China and Japan are just another brick in the wall.

Currencies today 12/29/11. American Style: A$ 1.0066, kiwi .7667, C$ .9765, euro 1.2888, sterling 1.5387, Swiss $1.0583. European Style: rand 8.1610, krone 6.0228, SEK 6.9324, forint 241.51, zloty 3.4470, koruna 20.1170, RUB 32.2205, yen 77.84, sing 1.3043, HKD 7.7738, INR 53.0562, China 6.3190, pesos 13.9917, BRL 1.8777, Dollar Index 80.722, Oil $99.58, 10-year 1.92%, Silver $26.68, and Gold. $1532.50

That's it for today.Well, so much for that quiet ending to 2011. I guess it's just par for the course in an otherwise extremely volatile year. It had its fair share of ups and downs but the long term focus hasn't changed. The University of Missouri recently switched conferences from the Big 12 to the SEC and the new football schedule was released for the upcoming season. I was looking forward to see Alabama make the trek into Columbia in mid October but my wedding, hi Sara, actually shares the same date so it looks like I'll have to catch the Tide on the next go around. On that note, it's time to get the day started, so until tomorrow.Have a Great Day.

Mike Meyer
Assistant Vice President
EverBank World Markets

Posted 12-29-2011 7:30 AM by Chuck Butler
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