Euro-zone Stress Tests and Systemic Risk Worries to Dominate EUR/USD Next Week
Why, despite such a weak report in the US, did the EUR/USD still end up moving in the greenback's favor, and what does that mean for the fate of the EUR/USD going into next week?
That's a questions we should be asking ourselves as we head into the weekend, and the explanation lies in the difference between systemic risk on the part of Europe while the US faces risks of weak growth and therefore a slower recovery. One is more extreme than the other.
All in all, we should continue to see the EUR pressured as we move through next week due to the focus on higher periphery yields, concern about Italy's banks, and the scheduled release of bank stress tests. The issue of systemic risk will be front and center as European bank come under the microscope. How many banks will fail certain stress tests and will require extra capital? We should be able to identify the weakest banks following this exercise. The focus will be on the stress tests themselves - the standards used to define a worst cases scenario and how much capital bank will need on hand.
Primer on Stress Tests and Implications for Euro-zone Banking System
From Bloomberg: “The euro also dropped against the yen as an internal EU document dated July 7 and obtained by Bloomberg News said banks that fail this year's round of tests may need to present plans for making up their capital shortfall by the end of September. Governments should be ready to step in and help banks as a last resort, according to the preliminary document, which was prepared by government officials from the 27-nation region.”
The first concern therefore is that countries will have to find money to help finance banks as a last resort, a sign of more possible bailouts. Can't get enough of those. However, since the last time the EBA ran these tests it has caused a good deal of movement to shore up weaker banks already.
“The EBA's aims are twofold: first, to strengthen the system by pushing banks that are thinly capitalised relative to their underlying risks into raising fresh equity: and second, to convince the world about that strength - helping investors, particularly from outside Europe, to differentiate among eurozone banks and stop shunning them en masse.”
The threat of the tests, combined with behind-the-scenes lobbying by Mr Enria among national regulators, has helped spur more than ?50bn of capital-raising in the past year - doing much to head off failures. Morgan Stanley calculates that 19 of the 22 listed banks that only marginally passed last year have announced capital raisings. The exceptions are UniCredit of Italy and Austria's Raiffeisen and Erste.
Here's Retuers take with a little bit more info about what happens to bank that do not pass the tests.
From Reuters: “European countries will support banks that fail stress tests if those lenders cannot raise capital from investors within six months, according to a draft EU document seen by Reuters. Lenders that nearly fail the tests will be put on a critical watch list in case they deteriorate further, the document says. Those banks will be given until the end of September to draw up a plan to repair their finances and then three months to implement it.
The Italian/German 10-year yield spread hit fresh euro-era highs amid fears that already fiscally stretched countries like Italy might have to dig into their pockets to bail out banks that fail the test as well.
According to the document, capital-raising plans should first be based on “private-sector measures, including ... retained earnings ... raising additional common equity or high-quality hybrid instruments from private investors, assets sales, mergers. But if the search for private capital leads nowhere, then governments should be ready to step in.
Officials do, however, make provision for “the extreme case” if efforts to rehabilitate a bank fail and it threatens wider stability, recommending “a process of orderly restructuring and resolution.”
These are important developments, and can hopefully act to increase confidence in European markets, but such tests create much uncertainty, as banks will have to come clean with their holdings which could mean certain banks take a pummeling.
The actual stress tests results come out on Friday July 15th, so we want to monitor the headlines, and see if there will be some speculative attacks on the EUR prior to the result. It's going to be a full week of financial press on the matter, and as we hear about more bank names that do not pass, we should expect volatility and EUR weakness. We want to monitor these headlines and watch investor sentiment as a result. If the stress tests are too light and we don't see many banks failing, it would put into question the credibility of the tests to begin with, though it could also show that banks have taken the proper steps to wall off any dangerous debt on their books.
Contagion and Widening Periphery Yields
For the EUR, this past week the worries over Greece spread to Portugal, thanks to Moody's downgrade, and that contagion has pushed up other Euro-zone periphery yields. Spain and Italy saw their yields spike. The downgrade of Portugal by Moody's was the main catalyst, then the fallout in Italy as its banking sector lost ground. But there may be future downgrades in the works that cause market unrest and weakness for the EUR.
From Reuters: “The Italian/German 10-year yield spread hit fresh euro-era highs amid fears that already fiscally stretched countries like Italy might have to dig into their pockets to bail out banks that fail the test as well.
We havn't gotten to the ongoing discussions and banks and other private bond holders participation in a second Greek bailout, which so far has not been able to be presented in a way that pleases the credit rating agencies, which would consider plans under consideration a “selective default.” This is connected with European banks because that is exactly the scenario we should see as a worst-case. If the stress tests live up to their purpose of instilling confidence we will look at the EUR/USD after the week is over and as we digest the news.
With all of these concerns I continue to hold a bearish view of the EUR even despite the weaker US non-farm payroll release. Therefore, my bias leans towards finding opportunities to short the pair. Let's go ahead and look at the EUR/USD chart.
Looking at EUR/USD Scenarios for Next Week:
General Backdrop for EUR/USD from the Tech Side:
The medium term ema's (21 in red and 55 in blue) showed a bearish crossover this week (marked with a down arrow), which puts us in bearish mode. I marked the previous crossovers recently as well. When we have the 21-ema below the 55-ema, we should be looking for chances to short until we have a bullish crossover. That fits with the fundamental bias we are leaning towards.
Price and the medium term EMA's are also heading below the longer term 200-ema (gray). That would line up all 3 EMA's on in bearish alignment. But really, the trend has been a sideways one, and that could indicate a preference for the pair to stay in a range, and we have to watch for that at the start of the week's trading.
We are building a downward sloping channel.
Price tested and bounced down off resistance at the 200-ema, as well as the 50% retracement level, a signal the price wants to remain bearish even after the poor US report on jobs.
Therefore let's have a look at the possible scenarios we can expect next week.
1. Heavily EUR Bearish Scenario - Bank stress test speculation causes a drop in European equities, and yields on Euro-zone periphery debt continues to remain elevated. Negotiations regarding bank participation in Greece deal hits further snags. We could have the EUR pressured by global growth concerns and general risk aversion after the US NFP report.
In this scenario, the EUR should be able to break this week's lows, currently around the 78.6% retracement of last weeks relief rally, and head towards the lows of our recent range near 1.41, and possibly depending on the momentum of the market break below towards 1.40. The first half of this scenario is one of our preferred scenarios.
2. Correction - Euro Finds Support - Following the slide this week, markets can come back and return some calm to periphery yields and equities are cautious as we await the stress tests and the US markets begin the start of earnings week. We see a corrective rally that breaks through the downward channel, and finds resistance at the cluster of EMA's as well as at the 50% to 38.2% retracement levels. We can have a labored rally as we await the stress test results at the end of the week. But it could still be susceptible to bad headlines mid-week.
3. Another Leg Down - Second Chance to Sell Euro - Following a correction and a labored corrective rally, the leaks regarding the stress tests reveal concerns about Euro-zone banks and we then see lower equities at the end of the week as results trickle in. We can also have weaker fundamental data upsetting market sentiment creating a “risk-off” environment. Similar fundamentals to the bearish scenario would be in play, just later in the week. Because we are meeting a confluence of resistance levels that too can help cause selling pressure.
This second change to sell EUR would first target the lows set at 1.42, and then the 1.41 level we had in the bearish scenario.
4. Further Rally - EUR Bullish - The least likely scenario with looking at the risk events arrayed next week, but one that can happen is following the test of resistance around the middle of the range, the EUR rallies further, back to the 1.4560 level. Investor sentiment would have to shift from the risk averse mode that ended this past week, to one that is strongly risk positive. We could also see the USD come under selling pressure because of the weak jobs report. It would mean the Fed may need to further push out any interest rate increases, which is USD negative.
We would also need to have some positive news on the sovereign debt front to replay the relief rally we saw 2 weeks ago. It seems we are far from the heady days of EUR gains on the back of the Greek austerity vote.
While the Euro-zone got past the problem of a short term default by Greece, there are plenty more troubles that will be hitting the EUR next week, so let's see if our expected scenarios (1 and 3) play out.
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