Sovereign Debt Foreshadowing Bigger Rally?

by Michael A. Gayed | June 18, 2012 10:47 am

Sovereign Debt Foreshadowing Bigger Rally?

“In the range of music we play — roughly 300 years’ worth — there really are more similarities than differences.” — Esa-Pekka Salonen

I’ve addressed the price performance of emerging-market sovereign debt a couple of times here on InvestorPlace as a way of gauging risk appetite.

In the latter half of May, there was a notable decline in the price of emerging-market debt as credit fears increased dramatically in a few short days. I highlighted this in an article on May 21[1], in which I showed the price-ratio collapse that was then occurring between the PowerShares Emerging Market Sovereign Debt ETF (NYSE:PCY[2]) relative to the iShares 7-10 Year Treasury Bond Fund ETF (NYSE:IEF[3]). The speed of the decline was ominous in that it suggested that an “event” may be upon us if a significant reversal did not occur.

Below is an updated chart of that price ratio. As a reminder, a rising price ratio means the numerator/PCY is outperforming (up more/down less) the denominator/IEF. pcyief061712 300x199 Sovereign Debt Foreshadowing Bigger Rally?
Click to Enlarge

I have highlighted the behavior of the ratio before and after the summer crash of 2011 (after which the October 3 low and ensuing fall melt-up began) and the behavior now.

As June’s trading took place and various market internals began reaching levels characteristic of what happens in the midst of an actual credit event and crash, a sharp reversal did indeed occur, and emerging-market debt came back strongly.

The “V” formation is a very positive sign, since it means the sudden fear of a credit seize-up that the price in May was then suggesting was a real possibility was not justified.

The implication, though, is perhaps more interesting.

Should the ratio continue to rally, as it did in October, it may be a sign that further gains are ahead for risk assets as continued healing in credit markets occur. This is but one of the many reasons I have been arguing recently that a situation similar to 2011′s fall melt-up may be under way.

The way to play this? Quite simply, be less bearish and consider that a big move higher in equities could soon occur in the face of the negative narrative that all too many know and thus have likely overestimated the odds of happening.

Endnotes:
  1. an article on May 21: http://investorplace.com/2012/05/the-new-cracks-in-sovereign-debt/
  2. PCY: http://studio-5.financialcontent.com/investplace/quote?Symbol=PCY
  3. IEF: http://studio-5.financialcontent.com/investplace/quote?Symbol=IEF

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