Euro Vulnerable as Markets Weigh Stress Tests, Short-Covering Slows

The widely anticipated EU bank stress test results have come and gone, with only seven of the 91 lenders included in the experiment failing to come out with a favorable outcome. 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. Judging by the market’s reaction, investors have been reassured, with the Euro managing to finish Friday’s session higher 0.1 percent higher against a trade-weighted average of its major counterparts.

However, as pointed out by DailyFX strategist John Kickligher, the seemingly sanguine reaction likely owed to thin liquidity rather than genuine confidence in the tests’ results. Indeed, 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. However, 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.

In short, 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 the Euro as liquidity returns next week. The single currency had been well-supported by short-covering as investors unwound record-high bets against it. However, the latest IMM positioning figures reveal that net speculative short exposure has now dropped below its year-to-date average, hinting that portfolio readjustment may prove to be an increasingly feeble force underpinning the exchange rate in the days ahead.