Stress tests not stressed enough

Europe has had time to digest the banking results that were released by the European Banking Authority (EBA) late Friday and the conclusion is they don’t change the landscape for Europe’s sovereign debt crisis one bit. Last year’s stress tests had limited impact on investor sentiment and the same has happened this time. Greek bonds are back at euro-era highs, Italian 10-year debt surged to 5.86 per cent, and German yields continue to fall as Berlin attracts safe haven flows.

While markets remain heavily focused on downside risks for Europe the stress test results are deemed too rosy. Only eight banks failed the tests and the total capital shortfall was a mere €2.5 billion. Over the weekend a number of large global banks conducted their own 'stress tests' that apply more realistic haircuts to sovereign debt holdings that are in line with market expectations. According to one, its results found a capital shortfall of €80 billion and 20 banks failed the test.

Spain, where five banks’ failed the EBA tests, hasn’t helped matters today. The Bank of Spain said that its lenders don’t need to raise any additional capital, yet its domestic caja banks are deemed some of the most at-risk from the fallout of the Spanish property bust. Today Bankia, one of Spain’s largest savings banks after seven caja banks were forced to merge last year, cut its IPO price by 26 per cent to €3.75 per share to try and woo investors during the heat of the sovereign debt crisis. Bankia just scraped though the EBA test with a capital ratio of 5.4 per cent (the minimum was 5 per cent).

Bankia will be considered a key litmus test for sentiment towards Spain’s beleaguered banking sector. Civica, another bank formed by the merger of caja banks, is due to go to market soon to shore up its capital bases If they achieve reasonable interest from investors then concerns about Spain may start to fade. But it is no mean feat. Already this year 21 IPO’s have been pulled or delayed in Europe, the most since 2008, so Spain might find that the problems in its banking sector may last for some time yet, and the government may still have to shoulder some of the bad loans to try and boost investor interest in its financial institutions.

The focus this week will also be on the 21 July EU summit to try and hammer out a deal for a second bailout for Greece. The pressure is on for the various branches of the EU to finalise plans for private sector involvement. Already the ECB and Germany are clashing over the prospect of a default for member states. This is likely to dent sentiment towards euro-based assets. 1.4040 in EUR/USD is a key support level, ahead of 1.4000.

Elsewhere, safe haven assets continue to surge. Gold breached $1,600 an ounce – a record high- and silver continues to make gains. Likewise, the Swiss franc and Japanese yen are also rising strongly, while riskier currencies look vulnerable in the current environment.

While today there is a dearth of economic data, there are some key things to watch out for this week. Obviously the EU summit on Thursday will require a clear signal on Greece’s second bailout to placate the markets. Spain is also scheduled to auction 10 and 15-year bonds on Thursday morning, the Bank of England releases the minutes from its latest meeting on Wednesday and there are is a raft of Fed speakers. Investors are focused on downside risks for now, and we think the uncertainty and market volatility is likely to prevail.

Kathleen Brooks is research director at Forex.com.

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