Sovereign Debt Foreshadowing Bigger Rally?

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

“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. 
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.

  1. an article on May 21:
  2. PCY:
  3. IEF:

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