European banks’ stress tests are out of the way now, but what effect did they have?

At a first glance, comparing the actual results with what was being expected; the actual figures revealed seven banks out of the 91 tested failed the test – and the expected figures were that ten banks would need more capital; results were quite in line and slightly more positive. In total, these seven banks would need to tap an additional €3.5 billion to be able to withstand another recession. But then why were investors so sceptical on the methodology used for the tests?

Well, firstly it is good to highlight that it was highly unlikely that the outcome of the stress tests would reveal a greatly troubled European banking system, given the EU’s approval for transparency of results.

Traders and analysts keep arguing that the criteria used for the stress tests was not credible or rigorous enough, as they believed that tests did not focus on entire balance sheets. “The lack of a test for sovereign risk means the test was too soft and not credible,” said one portfolio manager from Europe. “…. at some point the market will return and ask whether the criteria are sufficient to test the banks’ ability to withstand another sovereign-debt crisis”, added another analyst.

And if some of you were uncertain, when reading different sources, about the inclusion of sovereign debt or not as one of the criteria - please allow me to expand thereon. Evaluations took into account potential losses only on the sovereign bonds the banks trade, rather than on the sovereign bonds the banks are holding to maturity. Stress tests did not require any reduction in value for sovereign debt classified as hold to maturity – they only assumed the possibility of sovereign debt losses in trading portfolios. Therefore the impact of sovereign debt losses was included solely on trading books rather than on bank books as well.

However, following the results, banks gained support in European equity trading last Monday and even Tuesday. Despite any criticism with regards as to how strict the tests were, the results were a significant enough disclosure for analysts to make their own conclusions – and to distinguish the weakest banks. One must also note that having the tests out of the way is already a source of relief. But what happens to the euro now? Seeing the euro trade against the US dollar, last Tuesday, the pair were reaching highs of 1.3046 at the time of writing, which doesn’t seem to be in line with analysts’ medium term forecasts for the EUR/USD. The forecasts were suggesting that the pair would be touching the 1.10/1.15 levels again in due course. Well it might be that such forecasts would need to be re-visited.

Prominent players of the Forex markets are already factoring in a slowing US economic recovery and revising short to medium term forecasts up. When Fed chairman Ben Bernanke, in his recent semi-annual report to Congress, used words like “unusually uncertain economic outlook”, and “prepared to take further policy actions as needed”, it suggested that the Fed does not rule out a prolongation of monetary accommodation or at the least implies that interest rate hikes are being deferred. In addition the European debt crisis seems to be relatively stable and although there was criticism of stress test results, results were fairly harmless.

Taking parallels with last year’s US stress tests we must remember they were also criticised by some as not tough enough - but at the end they still helped big US banks’ share prices gain.

This does not imply that the euro remains risk-free, but that a number of risks are now being contained.

Up till early this week the Japanese yen was down 0.57 per cent against majors, with the biggest losses coming against the NZD. Most of this loss may be attributed to the coalition government’s view that Yen is excessively strong. On Friday CPI and industrial production are due to come out.

The British Pound gained a 0.16 per cent drawing support from stronger than expected Q2 GDP at the end of last week – however in the medium term a combination of fiscal tightening and loose monetary policy is expected to keep weighing on the British pound.

The Australian dollar was gaining support early this week, as analysts were expecting a significant rise in last Wednesday’s CPI reading, investors were speculating that a rate hike will follow – this gave the Aussie increased support.

A general improvement in risk sentiment earlier this week favoured the New Zealand Dollar as well. With data pointing towards a continued gradual economic recovery, analysts are expecting the RBNZ to keep hiking its policy rate and when compared to the US dollar, the difference in interest rate will keep benefiting the kiwi.

Upcoming FX Key events:

Today: German Unemployment.

Tomorrow: US GDP Annualised, US PCE, & Canadian GDP.

FX Technical Key points:

EUR/USD is Neutral. USD/JPY is bullish, target 98, key reversal point 85. GBP/USD is neutral. USD/CHF is neutral. AUD/USD is bullish, target 94.00, key reversal point 87.00. NZD/USD is bullish, target 0.78, key reversal point 0.7000.

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This information shall not be deemed to constitute advice and should not be relied on as such to enter into a transaction or for any investment decision. Any opinions expressed in this document represent the views of RTFX at the time of preparation.

They are thus subject to change without notice. RTFX believes that the information contained herein is accurate as at the date of publication. However, no warranty of accuracy is given by RTFX and no liability in respect of any errors or omissions, including any third party liability, are accepted by RTFX or any director, officer or employees.

Mr Muscat is senior trader at RTFX Ltd.

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