Euro Complacency And The Dollar Flight

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Summary

Stress Tests and bailouts.

Terror and tensions.

Big safe haven flight could occur.

It has only been a month since Britain's historic vote to leave the EU sent tremors amongst financial markets. Those tremors have largely subsided as the country settles into new leadership and has seen stability return to stock markets and sterling, but as the markets digest the numbers coming out of the UK, storm clouds are once again rising across Europe.

I wrote an article in November last year about the potential for a U.S. dollar rally amidst the expectation of further turmoil in Europe and the situation there is now building to a toxic mix of troubles surrounding three key areas: banking, politics, and war.

Stress Tests and bailouts

This coming Friday sees another round of ECB stress tests for Europe's troubled banks with concerns building around the Italian banking system, which currently groans under the weight of an estimated €360bn of non-performing loans.

Italy's third-largest lender, Monte Dei Paschi Di Siena (OTCPK:BMDPY), is largely expected to fail this test as the Italian Prime Minister, Matteo Renzi, tries to seek EU approval for a €40bn bailout for the nation's struggling banks- a bailout which he wants to fund with government debt. This would add further pressure to the fiscal and political strains in Italy, where anger over austerity has led to a sharp rise in the polls for the populist Five Star party. This is an uncomfortable moment for Prime Minister Renzi, who has staked his political career on a referendum in the autumn seeking reform to the constitution.

Monte Dei Paschi is based in the Tuscan region of Italy, where not far away, a collapse in another Italian lender, Banca Popolare di Vicenza, created millions of euros in losses for customers earlier in the year and the larger Tuscan bank could see thousands of Italians on the hook for losses under the recent EU bail-in rules.

A deterioration of the situation would likely signal the end for Renzi as leader, ushering in an anti-austerity party whose manifesto includes a return to the country's old currency: the Lira. A Brussels still reeling from Brexit, will want to avoid such a situation at all costs.

Italy currently has a debt-to-gdp level of 130%, which is second only to Greece, yet the economy is ten times larger. Further problems in Italy risk creating an almost insurmountable problem for the ECB.

Another bank which will be closely followed in the stress tests is Germany's Deutsche Bank (NYSE:DB), which has seen its share price fall 45% year-to-date. The company announced its second quarter results this week, which highlighted a 98% fall in post-tax profit as the bank seeks to pull-off a successful turnaround effort.

Deutsche Bank's CEO, John Cryan, was less-than-optimistic citing concerns about a post-Brexit slowdown: "We have continued to de-risk our balance sheet, to invest in our processes and to modernize our infrastructure. However, if the current weak economic environment persists, we will need to be yet more ambitious in the timing and intensity of our restructuring."

As with previous stress tests, the market may be dubious about the level of stress that balance sheets are subjected to with all that's currently at stake and any relief rally in the Euro would highlight the continued complacency that will soon recede.

Terror and tensions

Adding to the political instability in Europe is the now alarming regularity of terrorist attacks, particularly in France, and lately over the weekend in Germany, where many citizens are becoming concerned at Angela Merkel's decision to allow 1 million migrants to flood into the country almost unchecked. Merkel and France's Hollande will face their own elections next year and a deterioration in the economy or continued attacks could risk creating a populist revolt in Europe's largest two economies.

The concerns over security are shared in Hungary, where the populist leader is pushing back against Brussels' migrant policy and in nearby Austria, where the right-wing Freedom Party will get a shot at overturning the slimmest of election defeats after the first run was annulled on allegations of vote-tampering.

Further afield, the continuing war in the Middle East looms overhead, alongside the recent coup in Turkey and ongoing tensions with Russia, which adds to a potent mix of problems. Turkey for example is 5th and 7th in the list of the EU's top import and export nations so the current turmoil there could add to the current trade issues in the Eurozone created by Brexit and Russian economic sanctions. Russia is the number 3 trade partner of the EU and the EU is Russia's largest trade partner so the sanctions have only added to the economic slowdown in Europe, with a risk that further lows in the oil price could see a deterioration in Russian demand.

Big safe haven flight could occur

With all of this turmoil and risk there is a real risk that we could see an investor flight from the Eurozone as capital seeks a safe haven. The likeliest destinations for this capital would predominantly be the U.S.A. Other safe havens would be the UK, Switzerland, Japan, Australia and Canada. The fact that each of these nations is struggling with their own economic woes or political turmoil is probably the main reason why this movement has not been more pronounced thus far.

When I first wrote about these trends in November, I focused primarily on Greece and the war aspect, yet the situation has since deteriorated beyond anything I imagined. Although Greece has been out of the headlines due to the unpopular deal struck by the Syriza government, the turmoil that it caused in the Eurozone would be a drop in the ocean to those created by an Italy or a France.

As the ECB goes down further down the rabbit hole of monetization and ultra-low yields, the financial situation in Europe is at risk of a Lehman-style event if the governments of the Eurozone lose control of sovereign debt yields.

This problem was lurking in the shadows but the threats to security and the risk of populist revolt, or even civil wars could bring the crisis out into the open and further deteriorate the economic conditions in member states.

As I stated previously, I expect a 25% drop in the Euro to 80 cents (NYSEARCA:FXE) and a 20%+ gain in the U.S. dollar (NYSEARCA:UUP). I predicted this to occur by late 2016 so it should be underway by then, however the potential for a blow-off top in the U.S. dollar is now a possibility into 2017 if the toxic mix of problems spill-over and see the dollar forced to soak up huge capital flight like a sponge, which would then create headaches for the FED.

The market is getting complacent due to the mild effects of Brexit and is ignoring the growing trends of banking and political instability against a backdrop of war.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I am currently long U.S. dollar and will continue to seek opportunities.