Look to Fade Relief Rally

Big sigh of relief that European officials delivered the bare minimum amount of details of the new plan, which are largely as had been anticipated here and elsewhere. The broad outlines consist of a 50% haircut on private sector holdings of Greek bonds, leveraging the EFSF 4-5x for firepower of around 1 trillion euros, 9% Tier 1 capital by mid-2012, and ECB not involved with EFSF and leverage.

A SPV will be set up alongside the EFSF and there is still talk that the IMF may manage it and may seek outside investors. Talk yesterday of keen Chinese interest was sparked by unnamed European official comment not Chinese. The PRC seems supportive but what this means operationally is not clear. Sarkozy meets with Chinese officials soon, but concrete commitments will likely remain elusive.

The 50% haircut on private sector holdings does not reduce Greece's debt by 50%. Follow the logic here. Greece's debt is about 350 bln euros. Roughly 75 bln of which are in the ECB's hands and another 70 bln do not fall into the agreement. That leaves a 50% haircut on about 200 bln euros and that means 100 bln. That 100 bln is a little less than 30% of the 350 bln debt. .

That said, Greek pension funds hold about 35 bln euro in Greek government bonds and they will take the 50% haircut. Yet another example, how Greece is not really being bailed out. Greek workers and economy have taken and continue to take significant hits and pensioners will too. Greece's second aid package is valued at about 130 bln euros. The first 100 bln coming from the haircuts and the other 30 bln for EU/EFSF.

The global capital markets' sigh of relief is lifting equity markets, emerging markets and peripheral bond markets. Risk on and this is overwhelming everything else. That everything else includes a JPY5 trillion extension of the BOJ's asset purchases, a more dovish trajectory for Sweden's Riksbank, and comments form the BOE's Fisher than more QE may be delivered from the UK (though the CBI retail sales report was less weak than the market expected at -11 instead of -16).

The euro sold off from $1.4549 on Aug 29 to $1.3146 on Oct 4. It has been recovering since. The 61.8% of that rally comes in near $1.4013, which has been taken out today but additional upside momentum was modest and on short-term momentum indicators, there are modest divergences appearing, warning of the potential setback.

Sterling's last peak was Aug 19 near $1.6618. It fell to $1.5272 on Oct 6th. The 50% retracement comes in at $1.5945 and that is acting like support now and the 61.8% retracement beckons near $1.6104. That said, here too the short-term momentum indicators warn against establishing new longs now and instead suggest a near term pullback.

This is the move higher that I have been warning of, suggesting to prepare for, and to consider re-establishing short foreign currency positions. One argument against this is the talk of QE3 in the US. The initial reading of Q3 US GDP should ease such talk. Moreover, buying more MBS securities need not expand the Fed's balance sheet. And just as important, QE and currency movement is not what the text books would suggest. Sterling has gone straight up since the BOE announced QE and the yen is at record highs (vs dollar) even though BOJ continuing with its asset purchases and actually increased the size today.

There is still risk of further downgrades in the euro zone and growth forecast cuts (like in France) that will lead to more austerity and weaker growth. Slower growth in Greece that seems incredibly likely means that this might not be the final package for it.

At the same time, recognize that there is no substitute for disciplined risk management.