The ECB published results of the Asset Quality Review

Rates

On Friday, global core bonds climbed softly higher during European trading as risk off market sentiment reigned. During the US session, bonds returned these gains and closed near opening levels. Overall it was a quiet session anticipating the ECB’s stress test results. At the end of the session, changes on the German yield curve ranged between -1.4 bps (30-yr) and +0.8 bps (2-yr). In the US, yield changes were even smaller varying between -0.3 bps and +0.3 bps. On intra-EMU bond markets, 10-yr yield spreads versus Germany were small with an Irish (-3 bps) and Greek (-7 bps) outperformance.

On Sunday, the ECB published results of the Asset Quality Review. Taking into account end of 2013 balance sheets, the ECB found a capital shortfall of €25B at 25 banks. During 2014, 12 of these banks have already covered their capital shortfall (€15.56B combined). On a country-level, Italy was the big underperformer. Nine banks failed the stress tests and four banks still need to raise additional capital (Monte dei Paschi di Siena worst off). Spain was a positive surprise with only one failure for the stress test, but during 2014 their capital shortfall was erased. Spanish banks profit now from the efforts made after the 2012 national stress tests. On intra-EMU bond markets, Spain is expected to outperform & Italy underperform. The AQR also showed that banks overvalued their balance sheets by a combined €48B, €37B of which did not generate a capital shortfall. The AQR also found banks and national regulators were far too generous in deciding which loans should be classified as bad, identifying an extra €136B in non-performing exposures. The adverse scenario would deplete banks’ capital by €263B, reducing the median CET1 ratio by 4%-points to 8.3%. Overall, we believe that the results of the AQR are modestly positive for risk sentiment today. The outcome of the transparency-enhancing exercise will raise confidence in the financial sector. So, it improves the supply side of the credit channel but it doesn’t change anything for the demand side (lack of credit demand). It is up to fiscal authorities to provide incentives to stimulate growth and thus nurture loan demand.

Today, the eco calendar contains the German IFO business climate indicator, the euro zone M3 money supply and credit growth data and US pending home sales. The ECB will announce the amount of covered bond purchases.

After the stronger than expected EMU PMI’s, it will be interesting to see whether the German IFO business climate indicator shows a similar picture. The consensus is looking for a marginal worsening of the IFO indicator from 104.7 to 104.5 with both the expectations sub-indicator and the current assessment worsening slightly. After the significant improvement in the German manufacturing PMI last week, we believe that the risks for the IFO are on the upside too. This would be a welcome sign that the German economy is in better shape than feared recently. Also interesting will be the EMU M3 money supply and credit growth data. Growth in M3 is forecast to have accelerated further in September, from 2.0% Y/Y to 2.2% Y/Y. More interesting will however be the lending data. In August, there were cautious signs of improvement in lending to non-financials and it will be interesting to see whether a further improvement in seen in September. It will however be too early to see any impact from the TLTRO’s. Finally, in the US, pending home sales are forecast to show a limited increase, by 1.0% M/M in September following a slight drop in August.

Overnight, most Asian equity markets trade positive with China underperforming. We believe the ECB’s stress test results are modestly positive for risk sentiment. Election results in Brazil and Ukraine remove event risk and we interpret them as marginally positive for risk as well. Overnight, the US Note future opened lower but trades stable afterwards. This suggest a slightly lower opening for the Bund as well.

Today, the main item on the eco calendar is the German Ifo. We see risks for a stronger outcome which is a negative for the Bund. The ECB announces the amount of covered bond purchases last week. We believe that this number won’t be impressive, which raises chances of some disappointment. However, of late there is a “consensus view” in markets that the ECB’s announced programmes won’t be enough to substantially increase the balance sheet. While the relationship between core bonds and equities is asymmetrical of late (core bonds profit from weak equity markets whereas this relationship isn’t very strong in the opposite direction), we think that positive risk sentiment on equity markets could nevertheless have some impact on core bonds today.

Technically, the German Bund closed a second straight day below the uptrend line since June. This is a first indication that the bull run slows. A sustained drop below 149.91 (first test today?!) would change the ST technical picture to neutral. For the US Note future, attention will shift to Wednesday’s FOMC meeting.