Irish stress tests might not be stressed enough

It’s a fairly indecisive open to the European market today as investors wait for the results of the Irish bank stress tests later this afternoon and then the week’s main event: tomorrow’s US labour market report.

Stocks are down at the start of the session after Asian equity markets closed slightly higher. European stocks have had a good run in the last two weeks so a pause here prior the start of the Q1 corporate earnings season seems normal. The backdrop remains supportive for equities. Global growth appears to be on track and the Vix index – a measure of Wall Street’s risk appetite is low – which suggests investors are bullish about the market outlook.

The dollar is lower across the board today, which has pushed USDJPY lower and EURUSD and GBPUSD above 1.4200 and 1.6100 respectively. The prospect of the return to the carry trade funded by extremely low yielding Japanese yen gripped the markets this week as the Japanese currency started to weaken against its G10 peers.

However, although the yen is likely to be used as a funding currency, the carry trade could experience some bumps along the road due to two factors: 1, its sensitivity to risk makes it vulnerable to a reversal if fear about the Middle East crisis/ Japanese nuclear concerns once again grips the market. 2, USDJPY may not go up in a straight line. There is still a lot of uncertainty about the end of QE2 and when the Fed will start normalising interest rates. St Louis Fed President James Bullard said earlier this week that there may be a case to cut short QE2 to the tune of $100bn, but yesterday he tempered his remarks by saying that his view was not mainstream within the FOMC. This accounts for some of the dollar weakness today. We believe that this on-going debate about the world post QE2 will dominate the market in the second quarter and has the potential to cause volatility in the dollar and other risky asset markets.

Looking ahead in the next couple of days Republicans and Democrats will hash out a new budget agreement on up to $33n of cuts to avoid a government shut-down and potential default. This is being brushed off by the market as investors continue to believe the fractious parties will find some common ground in the days ahead.

They need to come up with an agreement to fund the government for the rest of the fiscal year – until September. Discussions have been going on for months. And highlight a big contrast between the US and Europe. Governments in Europe seem to be in agreement on the need to reduce deficits over the long-term, yet the US can’t agree on funding and spending cuts in the short-term. It will be interesting to see how long the market keeps its patience with the US and whether the market will eventually force US politicians to work together and bring down the country’s unsustainable debt burden.

Europe will be in focus today for two reasons: 1, Peripheral bond weakness and the release of the latest Irish bank stress tests and 2, the continuing inflation pressures that puts the pressure on the ECB to not only hike rates in April but to signal hikes further ahead at next week’s meeting.

Irish banks are expected to require a further EUR25 – EUR30bn of funding stress tests will reveal today. The IMF/ EU bailout funds can cover this, however, if the capital short fall is more than expected then more debt falls into the government’s lap. Ireland has been through this before, and capital requirements have so far proved to be inadequate. The stress tests, conducted by the Irish central bank, are harsher than they have been in the past, but they still might not be harsh enough. The adverse scenario will test banks for their resilience (or lack thereof) to unemployment jumping to 14.9%, yet it is already at 14.7%, so essentially we are already very close to the conditions described in the adverse scenario and things could get worse for the Irish economy before they get better.

Alongside the stress tests results there is a chance that the ECB will also announce a medium-term facility to help fund the Irish banks. This could go some way to help reduce the Irish state’s responsibility for its banks debts. However, the only way the State/ bank link will be broken once and for all is by a restructuring of bank debt, which may include private bond holders taking a hit. This is not likely to happen any time soon. Due to this we expect Ireland to continue to get hammered in the credit markets for some time.

European economic data has been worse than expected this morning. German retail sales fell by 0.3 per cent in February, and the initial annualised CPI estimate for March rose to 2.6 per cent from 2.4 per cent in February. This pushed EURUSD above 1.4200 as it made a rate hike next week extremely likely and increases the chance of further hikes beyond April. EURGBP has also rallied above 0.8800 as the market now expects the ECB to hike four times by year end relative to the UK’s two hikes.

Ahead today look out for Irish bank stress tests and US initial jobless claims data. It may be a quiet afternoon ahead as investors position themselves for tomorrow’s main event the payrolls report. Watch out for speakers from the G20 finance ministers meeting that started today.

Source: Forex.com

31.03.2011