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There are signs that European banks are not in the clear quite yet, and if anything, have been less than forthcoming about their problems. As the Euro struggles to break 1.60, traders are wondering what could cause the next big move in the currency. If European banks are forced to reveal larger than expected losses, we could see a major reversal.

It was just over a month ago when Bear Stearns’ shares sold off rapidly as rumors spread that they were having difficulty maintaining liquidity levels. In a matter of days, Bear Stearns was close to declaring bankruptcy and with encouragement from the Federal Reserve, JP Morgan Chase bought the firm out. It is this rapid and severe sequence of events that has left financial institutions around the world spooked and struggling to assert that they are healthy and operating fully despite tighter credit conditions.

Are these credit conditions actually tighter than Libor rates suggest? Probably. Last week, the British Bankers' Association (BBA) said that a review of the system that sets Libor rates that was initially planned for June is now “currently under way” amidst increasing questions about its reliability. Why is Libor so important? It serves as the global basis for interest rates on everything from derivatives contracts to corporate loans to mortgages. The calculation of Libor depends on banks - including Credit Suisse, UBS, HSBC, and Deutsche Bank among others - submitting on a daily basis what it would cost for them to borrow money across 10 currencies and 15 maturities, ranging from overnight to a year. However, the rates being incurred by banks may actually be higher than Libor suggests, as they under report borrowing costs in the fear of appearing desperate for funding.

Indeed, these concerns were practically confirmed a day after the BBA’s announcement, as Libor jumped to the highest levels since March 13 – when the Bear Stearns debacle was headline news – indicating that banks were rushing to report their borrowing costs more accurately. Clearly, this has huge implications for the global markets, as the gains will only drive other rates higher. However, the greater issue at hand is the sentiment it reflects amongst banks – there is no trust and there is no confidence. If a bank has to borrow at a higher rate, this suggests that the lending party views the borrower as a higher risk, and this is the primary reason why credit conditions are so incredibly tight.

These issues may take on a whole new meaning over the next few weeks, as European banks will start to report Q1 earnings. In the US, financial institutions have been put through the ringer, as Bank of America reported a 77 percent drop in net income while Citigroup announced a $5.1 billion loss and Merrill Lynch reported a nearly $2 billion loss. If the financials of European banks are anything like this, the news is likely to take a heavy toll not only on European stock markets like Germany’s Xetra Dax and France’s CAC 40, but could also weigh on the euro as well. Without a doubt, much of the currency’s appreciation to record highs against the US dollar has been based on speculation that the European financial markets and economy are in better shape than the US. If upcoming earnings reports indicate that the former is not true, and in fact, that European banks have been far slower to come forward and report writedowns and losses, the markets will likely start to bet that as the dominoes start to fall, expansion throughout the Euro-zone will falter.

Another major risk looms for the EUR/USD pair: Eurodollar futures. As you can see in the chart below, yields have recently broken above trendline resistance as they now trade just below 3 percent. This indicates that the markets do not see the potential for any additional rate cuts from the Federal Reserve, as they’ve already slashed the fed funds rate by 300bps since last September. This sentiment was exacerbated last week by hawkish comments from Philadelphia Fed President Charles Plosser, who said that real interest rates should be accommodative enough to “support the market forces that will bring economic growth back toward its long-term trend.” As a result, when looking at the EUR/USD pair, traders need to keep an eye on both sides of the coin as the Federal Reserve may start to fade from view while the European financial markets take center stage.

Written by Terri Belkas, Currency Analyst, DailyFX.com

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