Seeking Alpha

A Bold Trade Is Born In European Financials

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Includes: EPV, EUFN, EURL, EZU, FEZ, HEDJ, IEUR, IEV, SPEU, VGK
by: Michael A. Gayed, CFA
Summary

Everything is temporary until it becomes permanent. The ECB’s relaunch of a new QE package spurred controversy in the financial media.

Moreover, lowering the rate even more into negative territory spells trouble for European banks.

But there's more behind the ECB September package. If you scratch the surface a bit, exciting details make one wondering what the ECB did: ease or tighten?

The ECB’s interventions in sovereign bond markets should not be perceived or interpreted as “freebie” for governments. They are temporary. – Lucas Papademos

Everything is temporary until it becomes permanent. The ECB’s relaunch of a new QE package spurred controversy in the financial media. Moreover, lowering the rate even more into negative territory spells trouble for European banks.

But there's more behind the ECB September package. If you scratch the surface a bit, exciting details make one wonder what the ECB actually did: ease or tighten? I'm inclined to think contrary to the majority of investors. That's how a bold trade is born.

This week's Lead-Lag Report points out how European Banks (EUFN) may benefit from the latest ECB move. A glimmer of hope hidden under the new tiering system designed to help the banks. What if it works?

Some numbers always help. The ECB has about EUR1.8 trillion in excess reserves. Required reserves sit a little over EUR130 trillion.

Under the September announcement, the 6x multiplier of the required reserves acts as an exemption from the negative deposit rate of -0.5%. If one does the math and calculates how much is charged at 0.00% and how much at -0.5% the result is a blended rate of -0.27%. Compared with the previous -0.4%, that’s a hike, not a cut, of about 13 bp. No wonder bund yields reacted on the news by rising the most in eight years!

A falling wedge forming on the EUFN:XLF chart looks attractive. A constructive bullish setup, it points to a reversal if and when the lower highs series breaks.

When that happens, the risk-reward ratio for such a position looks attractive enough by all industry standards.

European financials sit at strong support too. With the price at the lower edge of a rising channel, it makes sense going long when the EUR:XLF falling wedge breaks higher. As for the target, the upper side of the channel should do the trick.

Under Draghi, the ECB acted as a champion of monetary innovation. Cutting the TLTRO rate further and paying zero interest on a larger share of reserves is nothing short of a deliberate distraction of what has actually happened last September.

Could this be the bottom for European financials? A quick look at individual banks show they all performed in a similar fashion. Thus, an ETF like EUFN provides a better investing alternative for this thesis.

Ongoing Brexit uncertainties coupled with new tariffs from the United States on European goods may challenge the bullish case.

But if this is how a bold trade is born, we might as well have one in front of our eyes.

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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.

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