Forex - FOREX: US Dollar Gains as Jittery Markets Await EU Stress Test Results

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The US Dollar rose on safe-haven demand as traders braced for the results of an already suspect set of European bank stress tests. More of the same is likely ahead.

Talking Points

US Dollar Gains on Safety Demand Ahead of EU Bank Stress Test Results
Stress Test Methodology, Administration Practices Appear Highly Suspect
Marginally Firm US Economic Data to Boost USD on Fading QE3 Hopes

The US Dollar perked up in overnight trade, rising against all of its major counterparts as investors turned defensive and sought safe haven in the greenback as the European Banking Authority (EBA) prepares to unveil the results EU bank stress tests meant to reassure investors that the region’s lenders are sufficiently capitalized and could withstand severe sovereign stress within the region. Early news reports – specifically, a widely-read piece from Reuters dating back to late June – suggest that 10-15 banks are likely to fail the tests, and this is likely to be the benchmark for the markets’ reaction to the final outcome. Traders will also pay close attention to the size of the recapitalization bill for those institutions that fall short.

Critically, the methodology of the tests is likely to get at least as much if not more scrutiny as the actual results. The same Reuters story quoted an unnamed central banker as revealing that national regulators were given sufficient leeway in the process to tailor the methodology so as to produce a desired number of failures, making the tests appear tough but not altogether damning. Similar issues arose with last year’s stress tests, where regulators didn’t test for the impact of a sovereign default on banks’ balance sheets despite that being the underlying reason for the exercise to begin with, and artfully failed to consider losses from sovereign debt holdings on lenders “banking” books (where securities are intended to be held to maturity rather, as opposed to “trading” books where they are not), where most such debt is held.

A report from Credit Suisse has already identified two tricky aspects in the way the tests are administered, wherein banks are told to assume their balance sheet will remain static while funding costs remain unchangedfor the next two years. Both assumptions promise to paint picture that is far rosier than it seems. Indeed, in an adverse scenario such as the one supposedly being tested, credit markets would seize up and banks would need to liquidate some of their holdings (presumably at a loss) to meet capital requirements. Furthermore, borrowing costs have already increased substantially for many European lenders and are likely to continue in the same direction if sovereign stress heats up, diminishing their ability to hold up in a crisis situation. More questionable practices may come up as the final outcome is reported.

Markets are seizing on the potential danger ahead, with S&P 500 stock index futures firmly in the red in late Asian hours and pointing toward continued gains for the safety-linked US Dollar against its major counterparts. On the data front, US Consumer Price Index and Industrial Production readings as well as the University of Michigan Consumer Confidence gauge are on tap. Core inflation is expected to nudge higher to 1.6 percent in June while industrial output growth accelerates over the same period. Meanwhile, consumer sentiment is expected to improve in July from the previous month. While the magnitudes of these generally positive outcomes are far from stellar, they are likely to prove sufficient to further blunt the likelihood of a QE3 program, compounding downward pressure on risky assets.

Source:
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