The last time that my thoughts were graciously accepted into this forum, I took the opportunity to explore the European sovereign debt crisis from a data-driven, balanced viewpoint. You may recall I proposed that, rather than suffering from a doomsday dismantling of the common currency, the euro zone was more likely in store for an extended period of sub-par growth. How appropriate then that my number should come up again on the very week that the European banking sector stress test results are released. As such, please allow me the luxury of indulging in this timely topic once more, albeit from a slightly different point of view, before moving on to more colorful subject matter in our next installment.
As of this writing, EUR/USD has rallied strongly off its June lows of 1.1877, gaining 9.00 percent and trading briefly above 1.3000 last week (Figure 1). The European Union's response to the debt crisis, while a bit clumsy and, at times, poorly communicated, clearly set a tone of proactive support for the euro zone and by extension the euro itself.
Figure 1
More recently, the foreign exchange market has been pacified by the positive results of sovereign debt auctions in Greece, Portugal and Spain. As the ECB has introduced a de facto guaranteed bid to the sovereign debt market, investors have been more willing to snap up the debt of these beleaguered nations. Indeed, Greece successfully issued EUR 1.6 billion of six-month paper at 4.65 percent, while Portugal tapped the same maturity at 1.95 percent.
Perhaps even more bullish for euro sentiment, however, was Spain's auction of EUR 6 billion in 10-year notes. It has been reported that China's State Administration of Foreign Exchange (SAFE), received up to EUR 400 million of this issue. This implicit vote of confidence in the euro zone, by the world's largest manager of foreign exchange reserves, was reinforced by explicit comments from Chinese President Wen Jiabao on his recent visit with Germany's Angela Merkel. Jiabao remarked that the European market would continue to be a destination for China's vast foreign exchange reserves.
These developments in the European debt markets, combined with recent weakness in U.S. economic data releases, have all contributed to an about-face in EUR/USD sentiment. To complete this picture, consider the dramatic swing in euro contract positioning as reported by the Commodity Futures Trading Commission (Figure 2). Futures positioning, widely taken as a proxy for large speculative bets, have backed off considerably from June's extreme negative levels. While clearly not overtly bullish, this does indicate a dramatic reduction in bets against the common currency.
Figure 2
This fundamental backdrop brings us to Friday's release of Europe's stress tests, which seem to have hit the markets not with a bang, but with a whimper. The results indicated that seven of the 91 banks tested would be required to raise additional capital totaling EUR 3.5 billion. These results were largely in line with expectations and the euro was little changed as a result.
Attention is more focused on the perceived flaws and lack of vigor in the tests themselves. While many and varied, the flaws most germane to our discussion of sovereign risks are strikingly simple: 1) there is no allowance made for a sovereign default (ostensibly because the European leaders would refuse to let this happen), 2) the haircut scenario tested provides for only a paltry 23 percent discount on Greek debt , 3) testing was applied only to assets on the trading books of the banks in question, excluding those classified as "held to maturity."
In all cases, the stress tests appear to disregard or downplay exposure to what has been at the heart of euro zone ills all along: sovereign debt exposure. This is not a complete loss, however, as data provided with the tests have given investors a glimpse into each institutions' holding of euro zone debt (with the notable exception of six German banks), allowing those inclined to conduct stress scenarios of their own and price risk accordingly. As occurred in the wake of the U.S. stress tests, this process may take slightly longer to unfold and work through the banking system. Note that Euribor, while dramatically below its 2008 crisis levels, has been steadily moving higher in recent weeks, indicating a tightening of credit and reluctance to lend in the interbank market (Figure 3). While it may be theorized that this move higher in the interbank lending rate is actually the positive result of banks relying less on ECB funding, it is logical to assume that if banks do become more comfortable as a result of the increased transparency provided by the stress test data, we should see that sentiment reflected in the level of Euribor to some extent.
Figure 3
From a broader perspective, the euro has thus far weathered the stress test release well, easily holding onto its recent gains. Technically speaking, EUR/USD has broken its long-term downtrend, opening up the possibility for a renewed push higher. However, from a fundamental standpoint, it is difficult to argue convincingly against a medium-term bearish outlook. Namely, while euro zone debt jitters have seemingly subsided, they have not disappeared. Although most of the indebted euro zone countries have completed the majority of their funding needs for the year, Portugal, Ireland and Spain will all return to the sovereign debt market during the first half of 2011. Until that time, when we get another read on global risk appetite for sovereign debt, expect markets to focus largely on the growth impact of austerity measures and short-term economic data releases, all of which have painted the euro zone in a comparatively favorable shade lately.
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