The Precise Take – New highs overnight; 7 Year Auction key today

Our ongoing hypothesis has been that the ability of the Treasury to fund the massive deficit spending of the US government is the key factor to watch this week to anticipate future market direction.  If the auctions were a great success, we would expect Treasuries to compete with equities for dollars and for equities to decline, with the world betting on deflation rather than inflation.  If the auctions were unsuccessful, we would expect equities to be more attractive and for long term Treasury yields to climb in order to make Treasuries more competitive (with the world betting on inflation).  An outright failure (nearly impossible as Karl Denninger notes because primary dealers are required to buy what others do not) would have disastrous consequences and would be largely unpredictable as to consequences.  We also believe that higher yields are Bernanke’s greatest threat because they exacerbate the upcoming problems with prime and Alt-A mortgages and commercial real estate loans that will need to be financed over the coming 18 months—a bigger problem than another leg down in the stock market.

We have looked to gold futures, long term Treasury futures and the EuroYen forex cross for signals as to how these auctions might proceed.  So far, they have signaled auction success, which does not track the reality of the poor showing of the 2 and 5 Year auctions Tuesday and Wednesday of this week.  As we updated yesterday, “though long term yields shot up on the announcement as expected, the ES has headed lower into support.  Support should hold and allow the ES to head higher and break resistance at 973.00.”  This did eventually come to pass, but the 30 year yield closed right back where it was before the auction. 

Accordingly, our primary scenario for the ES which has been on track so far (down into the afternoon yesterday, strong close, test of highs into Thursday morning, then lower into Friday close) is unfolding for reasons that violate our premises.  So, we are losing confidence in the scenario and are willing to put a 50/50 chance that the ES will now hit its next upside target at 1008 as early as tomorrow (Friday). Our market leaders are not as equity bearish as they were into the morning, so it is possible they were simply wrong a few days ago.  We will closely watch the 7 Year auction at 1:00 pm today and GDP tomorrow at 8:30 am.  A great auction and bad GDP can still send equities down, be we are not holding our breath now for that.  Today is another POMO day, and as we reported yesterday, the second POMO day of a back to back set does not have a bullish edge (nor does it have a bearish one).  See page 2.

As we write, the ES has shot up precisely to monthly R2 at 986.50 on the weekly jobless report.  Shorts will want this to be…

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