Focus is on how much money european banks will have to raise after ECB report

Outlook:

A little caution ahead of the weekend is only to be expected. Br azil holds and election, but the biggie is the ECB banking sector report on Sunday. The focus is turning from how many banks will fail to how much money the banks will have to raise. The WSJ names $12.6 billion, an easy number. Market News reports CitiFX summarizes the ranges like this: the number of failed banks will be from 10 to 20 or 10-15% of the 130 total banks, encompass as many as 6 countries, and name a capital shortfall of about €10 billion. The shortfall is actually more like €25 billion but €15 has already been raised. It will take a higher number of failed banks, over 15%, and a far bigger capital shortfall, to rattle the euro.

In the US, the upcoming stress tests for US banks, (31 biggies, including the Deutsche Bank US operation this time) will include a new entry, exposure to risky corporates. Yesterday the Fed disclosed details and the banks are to finish their reviews by year-end, with the Fed’s report coming out a few months later. The WSJ reports “As in previous years, the 2015 tests will include a sharp increase in unemployment—to 10% in 2016—and a significant retraction in economic growth. But the next round of the Fed’s “severely adverse” scenario includes a worse deterioration in the financial condition of large corporations, reflected by rising corporate-bond yields, especially for companies with high debt levels. Banks must show they can withstand losses from loans extended to those companies…. In addi-tion to the deterioration in corporate credit, the 2015 “severely adverse” stress-test scenario assumes a jump in oil prices to about $110 a barrel. Oil settled at $82.09 a barrel Thursday on the New York Mer-cantile Exchange.”

For the Fed to issue guidance on lending to risky corporates, which has been in the works for over a year and could come as early as next week, is a shocker. The obvious inference is that banks are too stupid to have good credit rules. If banks had good credit rules in the past, today’s bankers are too sociopathically greedy to apply them. This is insulting to good bankers but given recent events, probably all too true. We blame extending the bonus system from dealers and rain-makers to the blue suits and sometimes the brown suits.

The consensus is that the UK and US mostly fixed their banking sectors (with Canadians crowing that they didn’t need to because their bankers were well-behaved), while European banking is still a mess. The ECB report has to be seen as valid and definitive for the results to be trusted. If the results are trust-ed and the amount of capital to be raised is low, it’s possible the euro gets a lift. We can’t judge how much a lack of confidence has been a dragging force on the euro. But a known dragging force is the neg-ative interest rate on bank deposits. Market News describes a report from SocGen that points out interna-tional reserve managers (such as Taiwan) don’t really like not getting a return.

The negative deposit rate halts diversification of reserves into the euro dead in its tracks. SocGen says "While we estimate that part of the emergency selling is done, it is only a drop in the ocean of positions that still needs to move into the USD." About $2.9 trillion worth of euro foreign reserves "are at risk." If reserve managers move into dollars, they would tend to buy the 2-year maturity, although they might go up to 4-5 years. A realistic assessment would be "Assuming reserves at risk are all part of unallocated reserves excluding China and Taiwan, up to $253 billion of EUR reserves needs to be swapped or sold into dollars over time, capping the upside in EUR/USD." We don’t know if reserve managers have this mindset, but SocGen analysis tends to be astute and carry weight. So even if you like the idea of slowdown/deflation contagion from Europe to the US—and we do not—the dollar gets a boost on the reserve story. The question is when and how much. As a rule, we need to see the old low get taken out before we see momentum. That’s the Oct 3 low at 1.2501.

As for ebola stories driving risk sentiment, we are having a hard time swallowing it, although respected commentators are impressed and even the FT names the single New York doctor as the cause of equity index futures and note yields taking a dive this morning. Bloomberg asserts that “The yen halted a six-day decline against the dollar after a New York City doctor tested positive for Ebola, boosting demand for haven assets on concern the wider spread of the disease will crimp global growth.” Really? The threat of a pandemic in the US is extremely low. For this threat to affect financial markets means (1) lack of confidence in the US medical establishment, which can be blamed on the Texas hospital (2) mar-ket players don’t have enough to do. Earnings should drive equities, with the overall economy a factor, to be sure, but the tiniest of factors like a possible pandemic should be a tiny factor, not the driver.

If we are looking for off-the-wall pinball effects, we might better be looking at Russia. Experts say the only thing that can save Russia from financial ruin is a rise in the price of oil and gas. The FT cites Mor-gan Stanley analysts who say “that each $10 fall in the oil price cuts $32.4bn from oil and gas exports – equivalent to 1.6 per cent of economic output. If the aim were to keep government budget revenues from the oil sector constant in rouble terms, they add, the currency should weaken by 36 kopecks for every $1 fall in the oil price.”

Logically, if Russia wants to curry favor with the Saudis, they would have to dump support for Syria’s Assad, among other foreign policy actions. We have no idea whether the Saudis are motivated by this kind of consideration, but it would not be out of order in the grand sweep of history. Maybe the US and the Saudis are working together—who knows? But don’t take your eyes off Russia. On past perfor-mance, Putin is not going to take this lying down. The probability is high that he will retaliate by depriv-ing Ukraine and Eastern Europe, if not all of Europe, of energy supplies this winter. Wait for the coldest day and see what Putin has to say.

We think blaming ebola for a drop in equities, yields and the dollar is extremely stupid, but markets have been known to do stupid things for stupid reasons. Besides, it’s true that ebola is an evil virus for which there is no vaccine (yet) and no cure unless you can get the very best medical treatment and fast. Still, if you are going to worry about something this weekend, worry about the apparently muddy think-ing at the Fed. In Sept we had a dovish statement and a hawkish dot-plot. Since then we have had the idea of deferring the end of tapering and rebuttal of that idea—from both hawks and doves. It’s messy. We are going with the idea that it’s better to announce the end, the real, final end, of QE as the markets expect and not produce any surprises. Central banks like to plow the ground ahead of time and we don’t really have any hard evidence that ending tapering will be postponed. But still, what will the Fed state-ment actually say? Heaven forbid it says something along the lines of the Fed reserving the right to initi-ate QE4.