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Markets are taking a fairly dim view of the European bank stress test results, with the Asian session seeing a more defensive stance being taken towards the single currency.  The fact that the headlines put Spanish and Italian banks as coming out on top has been taken with a degree of scepticism by some, on the basis that these are where the bigger concerns lie on a country-wide basis.  

Furthermore, the tests ignored a scenario to which the market is giving a 90% probability of happening (Greek restructuring), which severely diminished their usefulness in the eyes of many.  Eight banks failed, with capital raising requirements of EUR 2.5bln, the latter being roughly similar to the shortfall in the 2010 tests. For FX, the Swiss franc and yen are the main gainers overnight, with EUR/CHF down to 1.1430, facing up to a seventh consecutive session of declines. Meanwhile, the US debt limit negotiations continue, so we are facing up to a long and potentially choppy week.

Guest post by FXPro

Commentary

European Central Bank continues to stress EU leaders.  The ECB leader has gone on record as saying that should Greece default, its debt will no longer be accepted by the ECB as collateral in its liquidity operations, leaving national governments to pick up the pieces.  This is not new news, but the fact that he’s underlining it ahead of this week’s EU summit is adding to the stress being felt, whilst German leader Merkel has said she is not turning up unless a Greek rescue plan involving private sector participation is on the table.  Whilst Trichet may be appearing stubborn, the fact is that he is steering a ship that was designed for a calm lake, that is now in open seas in a force 9 storm.

US situation goes far beyond the debt ceiling.  It’s pretty clear that throughout these negotiations, politicians have failed to grasp the enormity of the situation. This is illustrated by the strong desire to protect entitlement programs and defence. But with these making up nearly two-thirds of government spending, there is no way that the remaining spending can shoulder the burden of what is required, especially given that entitlements are only going to increase (in terms of money and proportion of GDP) over the coming years. Basic maths seems to be lacking, especially given also the ingrained rejection of any tax increases on the part of Republicans.  One of the common themes within what is going on in the US but also in Europe is that politicians are failing to grasp the essential conundrum behind the situation. We’ve obviously seen this with Greece, with the ECB also falling into this trap via its insistence that Greece must not be allowed to default, despite the fact that it’s the only way Greece will get its debt onto a sustainable level. In the US, the political system that is held up as the prime example of keeping politicians to account (namely 4-yr presidential election cycles and rolling congressional elections) also serves to ensure that politicians remains overwhelmingly focused on the short-term and their own political destiny. Hard and necessary choices on debt don’t come into it, unless it’s an opportunity to extract short-term political advantage. This is why if the US loses its AAA rating, it may well not get it back for many years to come.

Aussie dragged lower by rate outlook. On the majors, the Aussie is the only currency having a worse time of it than the euro, with sentiment damaged by talk of a possible RBA easing this year.  Lower rates are not such a big step from where we are. There have been signs that the domestic economy is slowing, with the 6-mth average of employment growth falling substantially, from 40k to 8k so far this year. The global picture cannot be ignored however, with the latest RBA statement following this month’s rate meeting reflecting the slowdown in both Asia and Europe. Indeed, the level of synchronicity in the global slowdown is likely to be the main factor that determines whether rates are reduced this year. If current trends continue – both a continuation of the ‘soft patch’ in the US and further slowdown in China – then Australia is likely to view the current ‘neutral’ level of rates as too high given the risks. However, it’s a game of relativity. Resource-rich Australia is still well-positioned for the coming years, from a fiscal position as well (public debt just over 20% GDP), so any rate move will be more a minor adjustment than the start of a protracted easing cycle.