Look Out the Euro! More risk aversion is on its way

June 25, 2010

TAIWAN/The upward correction of the value of the euro vs the U.S. dollar since early June this year may have given the impression that the debt crisis that has been weighing on the euro all year has started to dissipate.  Throughout this period, however, many indicators of risk have continued to flash warning signals and it is quite possible that the overall level of anxiety in financial markets may again be taking a turn for the worse.

The recovery in euro/dollar between June 7 and June 21 coincided with an improvement in the tone in equity markets. While both of these events have helped to massage investor confidence, Libor has remained elevated compared with its levels at the turn of the year and the cost of insuring bank debt has remained extremely high.

Suspicion and uncertainty about the level of bad debt in the banking sector, specifically in Europe, refuses to go away. In order to head off concerns about non-performing loans, the Bank of Spain recently agreed to publish the results of stress tests on its banks; a move which forced the ECB into promising that the stress tests on 26 of the Eurozone’s banks would be published.  Greater transparency had been demanded by the markets and is widely welcomed by investors. That said there is an obvious caveat to the publication of stress tests insofar as it does not guarantee that the news will be all good. The coming months could be a testing time for the European banking sector.

The President of the Banque de France, Christian Noyer, recently warned that some banks (in Europe) were already having difficulties raising capital. This was followed by reports suggesting that some banks in Greece, Ireland, Portugal and Spain were particularly reliant on the ECB for funding. Faced with the expiration at the end of June of the ECB’s 442 billion euros, 12 month loan, nervousness may soon rise some more.

To make matters worse, the Bank of England is claiming that if UK banks do not quickly raise 750-800 billion pounds in order to refinance their borrowings, the economic recovery may be at risk. Despite reports that the Spanish property  market may yet see prices fall by another 30 percent and related concerns about non-performing mortgage debt, the Spanish government has recently issued reassurances on the health of its banks.

The Irish regulator is expected to have completed stress tests on Ireland’s three nationalised banks by September; the Irish taxpayer having already paid a heavy price to avoid bank collapse. Given that sovereign balance sheets in general can ill afford to further support the banks, investors are likely to stay wary. It will be a brave investor that chooses to take on an aggressive long euro position in this environment.

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