Monday, 26 July 2010

Banks drive markets opening after Stress Test results

Europan Stocks opened today high, receiving well the positive results of Friday's Stress Test, but with no real euphoria. Banks lead the gains: Royal Bank of Scotland Group shares were up 2%, Lloyds gained 1.5% and BNP Paribas rose 2.5%, but the skepticism over the methodology of the tests could slow this initial sentiment down.

EUR keeps strong against the USD ending the week above 1.2900 but far from weekly highs that lie at 1.3028.

The results of the 2010 EU-Wide Stress Testing Exercise showed that 7 of the 91 banks tested failed the test, with a necessity of global EUR 3.5 billion extra capital in case of continuing crisis until end of 2011. In case of sovereign shock, the aggregate lost to the whole testing could be of EUR 67.2 billion.

According to the Committee of European Banking Supervisors and national authorities across the European Union, the seven banks that failed the test are Banca Civica, Unim, Espiga, Diada and Cajasur from Spain, ATEBAN from Greece and German HYPO. French, Portuguese, Italian, Finnish, Swedish and Belgium top banks all passed.

The US economy is not likely to slip back into recession

Sunrise Headlines

  • US Equities advanced on Friday as the European bank stress tests showed that 84 of 91 lenders had passed the examination, easing concerns about the health of the region’s financial system. This morning, most Asian shares start the week in positive territory.

  • On Friday, EU regulators said that only seven of 91 of the region’s systematically important banks failed the eagerly awaited stress test and would need to raise an additional €3.5 billion in capital, but some market experts were left sceptical that the tests were rigorous enough to restore confidence.

  • The US economy is not likely to slip back into recession but letting tax cuts for the wealthiest expire is necessary to show commitment to cutting budget deficits, US Treasury Secretary Geithner said yesterday.

  • European regulators have accused Germany and its banks of reneging on a deal to publish full details of sovereign debt holdings as part of the stress test exercise. Six of the fourteen German banks tested did not publish the expected detailed breakdown of sovereign debt holdings.

  • The UK economy grew almost twice as mush as expected in the second quarter, the fastest expansion for four years as rebounding services, manufacturing and construction ignited the recovery.

  • Japan’s government can’t continue to rely on excessive bond issuance to fund fiscal spending, the finance minister waned this morning, as the ruling Democratic Party officials wrangle over spending for the next fiscal year.

  • ECB policymakers increased pressure on Friday on industrialised countries to cut public spending immediately in order to consolidate the present recovery.

  • BP is poised to announce the departure of Tony Hayward, its chief executive, in the next 24 hours, according to people close to the company, the FT reports on its website.

  • Japanese export rose more than expected in June from a year earlier but the pace of increase slowed for the fourth straight month, a sign the economic recovery may lose steam.

  • Two top ratings agencies warned on Friday they might downgrade Hungary’s sovereign debt after its prime minister snubbed the IMF and rejected austerity measures in favour of a pro-growth policy.

  • Today, the eco calendar contains the US new home sales. Belgium and Germany will tap the market.


On Friday, the economic data in Europe continued to surprise on the upside of expectations. The German IFO indicator rose to its highest level in three years, confirming the improvement in the euro PMI’s. In the UK, GDP rose almost twice as fast as expected, due to a sharp pick-up in construction, but also the services and manufacturing sector enjoyed fast growth in the second quarter. GDP rose by 1.1% Q/Q, while a growth rate of 0.6% Q/Q was expected. The US eco calendar was empty.

On the markets, the strong European economic data didn’t go unnoticed, while investors were also waiting for the results of the stress tests that were published after the closure of European markets. This resulted in a further correction of global bonds, modestly higher equities, while commodities showed no firm direction. In the FX markets, the euro was little changed against the US dollar, but the dollar gained on the yen.

Intra-day, US Treasuries showed a very brief reaction on the release of the stress tests, but as equities ignored the results, US Treasuries rebounded to levels from before the release, only to drop later in the session when equities rebounded. The global bond markets were on the defensive on the back of excellent German IFO and UK GDP releases, which resulted in a down-move on the release itself. It was the second day in a row that global bonds corrected lower. While the stress tests were not published yet, we think that markets continued to look at them positively, which meant that risk aversion waned further. This was also reflected in the intra-EMU bond market, where spreads versus Germany across the board narrowed. Looking at a weekly perspective, the narrowing of the spreads versus Germany was especially an issue for Italian and Spanish bonds, much less for Portuguese, Greek or Irish spreads.

The European Bank stress tests delivered some surprising results. Indeed, only 7 banks, five Spanish saving banks, German Hypo Real Estate and the Greek Agriculture Bank failed and the global shortfall of capital is only €3.5B. In the US, the stress tests revealed that 11 of the 20 tested banks needed a combined €74.6B in fresh capital as a buffer for an adverse development of the banking environment. Some investment banks had done tests that revealed capital shortages of €38 to 85B. So, a number of analysts were quickly to dismiss the European stress tests as not severe enough. The critique understandably focussed on the absence of a default probability of sovereign debt in the banking books. The tests did take account of haircuts in the trading books, but about 90% of sovereign debt sits in the banking books and not the trading books. However, dismissing these tests on that argument would be unfair. The Bank Stress Tests were certainly tough enough with regard to all bank exposure (corporate, consumer, real estate) except the sovereign risk in the bank books, admittedly a big issue in bank balance sheets. The adverse scenario tales into account a double dip recession with negative growth figures both for 2010 and 2011 and declines in commercial and residential property prices, all adapted to the individual situation of the various countries. The stress tests also applied a tough interest rate shock that was more severe that the rise in rates in May. Short interest rates were upped 125 basis points to take account of a liquidity crisis and e.g. Spanish 5-year government yield was put at 5.78% in 2011, while the Greek one was 13.87%. This is a very severe shock that was applied to all bank exposure (except the sovereign risk in the banking books). The exercise resulted in a global loss of €566B over 2010-2011, or about €237B more than in the benchmark scenario, but except for the seven banks that failed the test, other banks have enough capital to face these losses. However, the main positive of the whole stress test may be the transparency and consistency. Everybody may now do its own exercise, also because the details of the sovereign debt exposure of individual banks are known (except for a small number of German banks that will come under suspicion of the market). This softens the criticism that the stress tests didn’t take sovereign default risk on the banking books into consideration. However, while one might eventually fear a default of the Greek government under some circumstances and eventually also some other smaller governments (as a catastrophic scenario), it would show that the overwhelming majority of banks could weather the storm. This means that the market may now start to discriminate between banks. Some banks that have passed the post may still be considered as risky and thus continue to have difficulties to get access to (money market) funding. However, the more general suspicion between banks may wane and thus there might be a normalisation of the money market workings. If this would be the case, the stress tests would have fulfilled their objective and a big obstacle to normalcy would have been taken away. However, the stress tests concerned the capital situation of banks. The longer term funding of banks remains a big issue for which the stress tests didn’t bring a solution. Banks will need to compete with governments that have still a big appetite for money to fund their deficits and refund their enormous debt pile. This might still restrain bank lending and cause banks to deleverage further. Overall, we think however that banking risk has diminished greatly after the stress tests. The ECB is still active on liquidity for months to come and in case of problems can still go further in providing liquidity. The Securities Market Program and the Covered Bond Program of the ECB, while on a low pace or stopped, are still available and a government backstop, the European Financial Stability Facility, is now operational. Concluding, one can always look for more negative scenarios, like most governments default, but these aren’t realistic and the risk test scenario looks a “realistic” risk scenario that most banks can cope with.

We will closely see how the Euribors and the liquidity premium on the money markets react, as well as European equities, the euro, the government bond yield spreads. Overall, we don’t expect any steep reactions in the various markets that have already anticipated a positive outcome. However, longer term it remains a positive that should underpin risky assets at the (small) price of core bonds.

Today, the eco calendar is thin as it only contains the US new home sales. On the supply front, Belgium (OLO March 2016 and Sep 2020 for €2-2.8B) and Germany (€4B Bubills) will tap the market. Belgium cheapened recently versus peers which might attract investors. Most investors will chew and react on the publication of the stress tests. Later this week, the EMU and US eco calendars are not too important expect for the M3 and EU confidence indications in EMU and the GDP and Chicago PMI in the US. More attention will go to supply in both EMU and US, albeit it in holiday- thinned markets.

After a dramatic drop of almost 33%, US new home sales are forecasted to show a slight rebound in June. The consensus is looking for a 6.7% M/M increase, but we believe a weaker outcome is not excluded. Later this week, the euro zone M3 money supply and credit growth data, euro zone CPI and the US Q2 GDP data will receive some attention. Last month, the euro zone lending data showed an increase in lending to non-financials, which might be a first indicator that lending to the private sector might be starting to pick up. It will be interesting to see whether lending to nonfinancials increases further in June, as it is an important factor for the recovery to gain strength. In the US, growth is expected to have slowed somewhat further in the second quarter (2.5% Q/Q from 2.7% Q/Q). We have no reasons to distance ourselves from the consensus, but a weaker outcome won’t go unnoticed as will raise fears for a double dip, especially in the US as UK GDP came out surprisingly strong last Friday.

Regarding bond market trading today, as expected the Bund correction continued at the European open (or at least the after-official trading dip on Friday was confirmed). We have long advocated that the Bund had slid in a sideways trading range between 129.93 and 127.60/12, but the Bund remained stuck near the top side of the range. On Friday, the Bund showed signs that it might test now the downside of the range and this might be the issue for this week. We stick to the view that dropping below that range would be difficult, but if the market would enthusiastically react on the stress tests (not our main expectation, see above) a sustained drop below would be a warning signal that a more pronounced correction is in store. Given the months long safe haven status of the Bund, such a deeper correction cannot be excluded though. For the US Treasuries, the situation is bit different. The Sep Note future is still in an uptrend (uptrendline is tested now) and key support is still further away, notably at 121-20+. For the US, one should take into account that the eco data have shown signs of weakness.

On Friday, the market talk was on the outcome of the stress tests for the European banking sector. As was already the case for quite some time, this was a debate between believers and non-believers. For the euro, one would expect this uncertainty to be a (slightly) negative factor. The pair started the session in the 1.29 area. However, after the very strong PMI’s on Thursday, markets also had to keep an eye on the German IFO indicator. As was the case for the PMI’s, the IFO was again much stronger than expected and just as was the case on Thursday, the UK data (Q2 GDP) were also much stronger than expected. This pushed EUR/USD to an intraday high at around 1.2965. However, the stress tests were too much of a factor of uncertainty. The euro had to return the early gains soon and a defensive repositioning hammered the single currency early in US trading with the pair testing bids just below the 1.2800 mark. The publication of the test results caused some temporary volatility with EUR/USD moving up and down between 1.2800 and 1.2900. However, looking at the (US) indicators of ‘stress’, investors at least came to the conclusion that the outcome of the test didn’t contain any unexpected negative news. Equities turned north and the VIX volatility indicator eased. Finally, EUR/USD closed the session at 1.2909, very close to the 1.2893 close on Thursday.

We made an assessment on the outcome of the stress tests elsewhere in this report. A lot of issues could have been addressed in a different way. However, for us, the bottom line is that the outcome of the stress tests should be a (moderately) positive factor for the European markets. So, while the immediate impact on the euro has been limited until now, we would consider it as mildly positive. At least, it removes an additional factor of uncertainty. From a market point of view, the question is now whether this factor will be enough a reason for a new up-leg in the euro. In this respect, we are still inclined to hold on to our view that the euro has already succeeded a nice rebound, admittedly from distressed levels. Nevertheless, the easing tensions on the intra-EMU government bond markets, the outcome of the stress tests and, last but not least, the strong eco data as published at the end of last week are all euro supportive factors. So, in a day-to-day perspective, we wouldn’t be surprised to see EUR/USD go for a (re)test of the 1.3029/95 resistance area. We stay open-minded, but don’t anticipate on a sustained break of this level yet. Today’s data (Chicago Fed and Dallas Fed indicators and the New homes sales) will probably have no lasting effect on trading.

Sterling had quite a good run on Friday. EUR/GBP was changing hands just above the 0.8400 mark at the start of trading in Europe. There was a brief up-tick after the publication of the strong IFO release in Germany. However, half an hour later, the UK Q2 GDP release came out much stronger than expected. EUR/GBP turned south. This move was both sterling strength in the wake of the strong GDP figures but it was also global euro weakness going into the publication of the results of the European stress tests. The pair dropping below Wednesday’s/Thursday’s lows even accelerated the move. The pair reached an intraday low at 0.8318 late in European trading. The publication of the stress tests results finally gave the euro some downside correction and EUR/GBP joined this move. The pair closed the session at 0.8372, compared to 0.8449 on Thursday.

Last Friday’s GDP data will make the debate at next week’s BoE meeting ever more interesting. Recently, it looked that the ‘Sentence’s view’ was only an outlier within the MPC and that the doves would maintain the lead. Even a further easing of policy was not ruled out yet. However, after Friday’s strong GDP data, the case of the doves hasn’t been strengthened. We expect the BoE to maintain a wait-and-see approach for now. So, we still don’t bet on the ‘Sentance’ camp gaining much more ground. So, in this context, we don’t see a reason for EUR/GBP to break out of its recent consolidation pattern anytime soon.

On Friday, there was again no big story to tell on USD/JPY trading. The pair moved gradually higher throughout the session. Trading was mostly driven by technical considerations. The dollar profited overall from some investor caution on the euro going into the publication of the stress tests. At the same time global sentiment on risk as mirrored in the equity markets’ performance wasn’t that bad. So, the pair finally managed to create somewhat of a buffer from the recent lows and closed the session at 87.46 from 86.95 on Thursday evening.

This morning, Asian equity markets are modestly higher. However, in line with the price action of late USD/JPY fails to draw much support from this. The downside in this pair is a bit better protected now (probably also as the market fears BOJ action in case of a drop to the 85.00 area). However, the pair obviously needs very high profile positive news to make any further progress. As we don’t see a trigger for such a news flow anytime soon, the recent stalemate in this pair might still continue for a while.

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