Euro, Risk Appetite Threatened as EU Stress Tests Remain in Focus

Key Overnight Developments

• Yen Slumps as Carry Trades Follow Stocks Higher in Asian Trade
• Japanese Exports Slow as European, Chinese Demand Weakens
• Australian Producer Prices Post Largest Increase in a Year in Q2

Critical Levels

The Euro and the British Pound ticked higher to start the trading week, adding 0.1 and 0.2 percent respectively against the US Dollar. We remain flat EURUSD and GBPUSD.

Asia Session Highlights

The Japanese Yen declined against all of its major counterparts as carry trades funded cheaply in the perennially low-yielding currency followed stocks higher in Asian trade. The MSCI Asia Pacific regional benchmark equity index climbed 0.5 percent to a monthly high, with the rally chalked up to last week’s seemingly encouraging EU bank stress test results. However, there is ample room to question the outcome (see below), hinting the upswing in confidence may prove to be short-lived.

Separately, Japan’s Trade Balance surplus widened to 687 billion yen in June from a revised 320.9 billion in the previous month. The details of the report proved far less encouraging than the headline figure would suggest, however. Indeed, exports rose at an annual pace of 27.7 percent – the slowest in six months – on waning demand from Europe and China. More of the same is likely ahead as Europe moves toward austerity to trim its high debt levels while Beijing hits the brakes on its buoyant economy amid fears of asset bubbles and runaway inflation. This bodes ill for Japan’s overwhelmingly export-driven economic recovery, hinting a slowdown is head. Indeed, a survey of economists polled by Bloomberg predicts GDP will grow at an annual pace of 1.7 percent in the second quarter, down from 5 percent in the three months through March.

Australia’s Producer Price Index rose 1 percent in the year through the second quarter, putting the annual pace of wholesale inflation at the fastest in a year. Still, upward price pressure remains tame, hinting the RBA may not be in a hurry to resume raising interest rates in the near term as policymakers size up the slowdown in China, Australia’s largest export market and the engine behind the mining boom that had kept the antipodean economy relatively insulated from the 2008 global economic meltdown.

Euro Session: What to Expect

With nothing on the economic calendar, risk sentiment is likely to take the top spot as the catalyst driving currency market price action. US equity index futures are trading narrowly higher in late Asian trade, but confidence looks vulnerable as European investors get their chance to price in last week’s release of EU bank stress test results strategically released after the region’s bourses closed on Friday. The headline outcome looked promising, with only seven of the 91 tested banks failingthe experiment. These firms will need to raise a combined 3.5 billion euros to bring them up to snuff – a pittance compared with what the market had expected.

However, there are ample reasons to see the results as suspect. By any measure, the aim of the exercise was to show that European banks are adequately capitalized to withstand a sovereign default within the EU or its immediate periphery. Interestingly, the Committee of European Banking Supervisors (CEBS) that administered the tests apparently ignored the majority of banks’ holdings of sovereign debt. Indeed, CEBS said it only took account of losses on those government bonds held on lenders’ trading books – a small minority of their total holdings – most of which sit on their banking books (meaning the bonds are intended to be held to maturity rather than actively traded). Banks need to write down losses from these long-term holdings only in the event of serious doubt about the government’s ability to meet its obligations, which is precisely what would occur in a default scenario.

On balance, it would appear the stress tests were not nearly rigorous enough to truly instill confidence in the European banking sector, a reality that may prove to weigh heavily on risk appetite and the Euro alike.

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