I haven’t seen much discussion on these, and how to plan for the likely outcomes. Here’s what you need to consider.Greek Bond Sale
On Tuesday July 20th, EU sovereign credit concerns are again tested as Greece attempts another 1.5 billion euro auction of 13-week bills July 20th.
There is only a low probability of failure given close EU monitoring and support. A failed sovereign auction is the most likely cause of an EU crisis, and everyone knows it by now.
However, if the demand is somehow low OR rates continue to climb, markets could freak once againEU Bank Stress Tests – Questions The EU Must Answer
Dangerous But Moderate - Medium Risk
There haven’t been so many key unanswered questions surrounding a key risk event since…. the first EU Greek rescue plans early this year.
The EU would spare no expense to save Greece – but no cash would be needed
A plan was in place – to make a plan at some point if needed, details to follow when needed (?)
There was an agreement… somewhat
The cash was ready…pending approval of the legislatures, courts, etc.
We hope the EU has learned its lesson and will leave no significant ambiguities this time. Still, the EU has resisted publication of these until now – a fact which is in itself troubling.
Here are just some of open questions the EU MUST answer if markets are to regain any trust in the EU banks and relieve the ECB of responsibility of sole lender
- What specific criteria will be used to determine whether a bank has passed the stress test?
- How clear are the definitions / classifications of different types of assets/liabilities, and what safeguards were in place to prevent misleading financial statement classification? The question is far from theoretical. In the US this past week, Citigroup revealed how they actively misrepresented their financial statements
- How will the EU calm markets about the numerous regional banks that are not covered yet have the higher failure risk
- Will there be detailed grades or a simple pass/fail? If not, will there be detailed notes to fill in the blanks?
- If a bank fails the test, how long will it have to raise the funds, where it will come from, and what measures will be taken in the interim period to protect the bank, its depositors, investors, and creditors?
- For sovereign bond holdings, by what amount should bonds of different governments be written down to account for default risk?
- Is there a clear mapping of interbank exposure? That is, if one fails, what others are at risk.
There are other questions of course, like how badly rising rates would hurt their lending revenues, etc. Results are widely expected to paint a rosy picture, and EU officials have been uniformly confident, including the Spanish. This seems incongruous given that Spanish banks have been forced to rely so heavily on the ECB for short term fundingWhat To Do
Given the number of questions that remain outstanding at this time, both the results and market reaction to them, remain impossible to predict.
What we can do is make plans for each contingency.
If The Questions Are Not Answered
The market’s reaction to ambiguity will be quite predictable - further declines for risk assets, especially anything associated with the EU, like the Euro and European stocks, though most risk assets will follow them down given the importance of the EU and uncertainties regarding systemic risk.
Expect gold to soar, ditto the safe-haven JPY and even the US Dollar, despite its own recent fundamental troubles. While the CHF is also a safe haven, and Swiss National Bank (SNB) has stopped intervening to keep the CHF from appreciating vs. the EUR, the Swissie may well sell off given Switzerland’s dependence on European export markets. The GBP might suffer a bit due its close ties to Europe as well.
If Canada continues to raise rates as expected, and it’s economy continues to improve, the CAD could start to take more of a safe haven role despite its ranking as the #3 risk currency.
Those not wishing to play the currencies or stock indices themselves can use the related ETFs. Some are better surrogates than others, so do your homework. These include:
For the S&P 500: SPY
For Gold: GLD but only in the short term
Forex: From Lowest to Highest Risk
USD (long) UUP
USD (short) UDN
If The Results Are Essentially Clear
If there are relatively few failing banks and clear plans on how to deal with the troubled ones and as yet unknown troubled banks: expect a rally in risk assets, particularly the Euro and other EU related assets like the CHF.
Significant numbers of failing banks, borderline banks: unclear how markets will respond. That will depend on what contingency plans are revealed for protecting depositors, creditors, and those depending on these banks for credit.
Also, markets may well respond positively just because uncertainty is removed and the EU appears to be confronting the issue of problem banks rather than avoiding it.
No plans concrete plans to deal with untested regional banks: market response to depend on estimates of how many banks are at risk. If the number is substantial, that failure to address the issue could rattle markets. Market response will depend on how serious the risk is. I really don’t know how that would be gauged.
Disclosure: No Positions