Fears of a wider European sovereign debt crisis swept global markets Tuesday, and could be a negative Wednesday as the Greek bailout seems to flounder.
Stocks Tuesday sold off sharply as the euro sank to a one-year low, gold rallied, and investors sought the safety of U.S. Treasurys and German Bunds. The yield on Greece's 2-year note shot above 16 percent, as Standard and Poor's downgraded Greek debt to junk status. S&P also lowered its rating on Portugal's debt, sending spreads wider on the debt of the fiscally weakest nations of Europe.
"Unless something dramatic happens, European markets are going to open weak and we're going to follow," said Tim Smalls of Execution LLC.
Besides Europe, markets are watching the outcome of the Fed's two-day meeting Wednesday and another heavy calendar of earnings news.
The euro Tuesday lost nearly 1.5 percent against the dollar, in its biggest one day fall since December, 2009. It was at a level of $1.3176.
"I think people have grossly underestimated the significance of what's happening in Europe," said David Gilmore of Foreign Exchange Analytics, who said the situation is not unlike 2007/2008. "Instead of Lehman triggering a systemic shock, we have the chance of a sovereign debt crisis triggering a systemic shock."
Greece has been promised aid from the IMF and EU but progress has been slow, in part due to political concerns in Germany. "The irony (Tuesday) was that (Jean-Claude) Trichet, the head of the European Central Bank, was in Chicago giving a speech about how officials need to do a better job managing crisis, and he was talking about the 2007 one, not the one that was on his blackberry," Gilmore said.
IMF Managing Director Dominique Strauss-Kahn and Trichet are expected to meet with German parliamentary groups in Berlin Wednesday. News reports quote sources saying German Chancellor Angela Merkel's Christian Democrats will raise the idea that investors take a haircut on Greek debt.
"The bottom line here and that perhaps policy makers underrate is that there is more at stake here than the outcome for Greece. What starts off as a sovereign crisis in Greece could very well become a European banking crisis," said Mark Dowding, DB Advisers head of institutional fixed income, Europe.
Dowding said some investors will be forced sellers of Greek paper because of the S&P downgrade, and some funds will remove Greek bonds form their holdings. "Unless there's some intervention here, unless there's some action, we're going to see a situation where yields continue to rise in Greece, and for that matter in other countries in Europe. There is a clear requirement for policy intervention here," he said.
"If Germany steps up to the plate, and says here's the money and other European countries also say we'll give you the money, that should stabilize things," he said.
"If bonds are defaulting and there's a lot of contagion risk, not just with Greece, but countries like Portugal, Spain, Ireland and Italy, on the idea that if nobody is going to be there to support a member state like Greece, it's basically every man for himself...I think there's a lot at stake that needs to be appreciated," he said.
Analysts also say the very structure surrounding the euro currency itself is at risk if European nations let Greece or other countries fail.
"It's for these reasons, we do think ultimately Greece will get some sort of support package, agreed at the last minute. The clock is ticking down, and I wouldn't want to guess how many days or weeks, but it's not months. The end game we're talking about is whether Greece defaults on its debt," Dowding said.
Gilmore said the euro appears to be finding support from a major buyer, as it should have already fallen further than it has on the Greek crisis. He speculated the buyer could be China or perhaps other emerging market central banks that were holding euro reserves.
Beyond the calamity in Europe, the market should receive another dose of positive earnings news from U.S. companies, which have been getting increasingly more comfortable talking about future prospects. Just Wednesday, DuPont and 3M joined the chorus of companies that beat earnings forecasts and see much improved outlooks for 2010.
The Fed is not expected to take any action on rates or drop the language in its statement that it would keep rates low for an "extended period." The Fed releases its statement at 2:15 p.m.
But in contrast to the fears that have been swirling in European credit markets, the Fed may sound more positive on the U.S. economy than in previous statements.
"They're bullish on the economy but inflation is actually lower than their targets..They'll sort of be like Goldilocks, not too hot, not too cold," said Mesirow Financial chief economist Diane Swonk.
Stocks have been drifting higher on better earnings and economic news, but many traders have been expecting the market to take a pause during earnings season.
Wednesday's decline was the biggest drop since Feb. 4. The Dow fell 1.9 percent to 10,991, and the S&P 500 lost 2.3 percent to 1183.
"The market did slice through the uptrend that's been in tact since Feb 5., and there's definitely some technical damage," said Scott Redler of T3Live.com, who follows the market's short term moves on a technical basis. "The last time we broke this uptrend in January, it did lead to a nine percent correction."
"At this point, we're at a major inflection point. This time it seems like we're too high. There's too many problems right now and there's too much headline risk," he said. "We'll look to see if the dip can be buyable. One level I'm watching is 1155 to 1160 (on the S&P), which is a 5 percent correction."
Redler said even if the market finds its footing after a weaker open, Wednesday's trading still should not establish the low of the current move lower. "We were 10 handles away from the 62 percent retracement of the entire 2007 to 2009 bear market down move. That was at 1227. 1217 was our intraday high. We were also 7 handles away from the 200-day moving average on the weekly chart," he said.
The Treasury is also expected to auction $42 billion in 5-year notes Wednesday, after Tuesday's auction of $44 billion 2-year notes was softer than expected. "I think the 5-year note will have as much trouble as the 2-year did, if we stay at these levels. The 2-year was pretty sloppy. The foreigner was not a big part of the auction," said John Spinello, Treasury strategist at Jefferies.
Earnings expected Wednesday include Royal Dutch Shell, Honda, Comcast, Dow Chemical, General Dynamics, Northrop Grumman, Owens Corning, Thermo Fisher, Massey Energy, Barrick Gold, Canadian Pacific, and Hess. After the bell, Visa, Allstate, Baidu, Express Scripts, Owens-Illinois, Xilinx, Varian Medical and Akamai report.
Markets are also focused on the investigations into Goldman Sachs , both by the SEC and the Snate committee. A day long hearing Tuesday before the Senate permanent committee on investigations dragged into the evening Tuesday, as a parade of Goldman executives, including CEO Lloyd Blankfein, were interrogated. Financial regulatory reform will also stay in the headlines, as another Senate vote failed Tuesday afternoon.
Traders watched the Goldman hearings with interest, but they said it was the news from Europe that moved the markets.
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