Deutsche Bank Crashes but EURO Does Not, Here's Why

The biggest story in the financial markets today is Deutsche Bank and the growing fear that they will become the next Lehman Brothers. In the last 24 hours shares of DB has fallen more than 7% intraday, the Dow dropped nearly 1% and currencies are falling out of bed.  Risk aversion permeated the market on reports that the bank's hedge fund clients are withdrawing excess cash, lowering collateral on trades and generally reducing their exposure to the bank. DB has been plagued with troubles for the past few weeks but as the company's stock extended its slide, the tension turned into greater risk aversion.  

 

Interestingly enough EURO was not the hardest hit currency. In fact it ended the day unchanged against the greenback with its losses paling in comparison to the slide in AUD/USD, USD/CHF and even GBP/USD. If this were truly a Lehman moment for Europe, EUR/USD would be trading much lower.  We see only two explanations for the currency's resilience - German yields are up and U.S. yields are falling or the majority of investors still believe that Deutsche Bank is too big to fail. CEO Cryan argues that the company has tremendous liquidity reserves and raised another $1 billion euros from its sale of Abby Life.  But the problem is that they could owe up to $14 billion to the U.S. Department of Justice who is charging the company for legal costs and settlements related to their investigation into the bank's mortgage backed securities. Investors fear that this expense would cripple the bank financially.  At first there was hope that the German government would provide a bailout but they denied claims that they are preparing a bail out while CEO Cryan said its not an option. In response institutional and retail investors pulled their funds putting the bank into a greater cash crunch.  Deutsche Bank's fate has significant ramifications for global markets because they have deep connections with financial institutions around the world and many companies will be affected by their insolvency. 

 

The big question now is how DB will raise capital and currently their main focus is selling off profitable businesses.  Unfortunately the only way to stop this crisis of confidence is for Chancellor Merkel to offer a bailout. The problem is that its politically unpopular and next year is an election year. Merkel has been a vocal opponent to putting taxpayers on the hook for bank bailouts but at some point, the economic consequences could outweigh the political fallout. The only "other way" we see the DB crisis settling is if the bank manages to substantially negotiate down the DoJ's fine. Of course they'll probably have to cut bonuses as well since that could easily save them 1 or 2 billion euros but the first two options would do a better job reversing market sentiment.  Deutsche Bank's troubles have also raised concerns about other banks in Europe - Credit Suisse and Barclays are also in mortgage settlement talks with the U.S. government.

 

The bottomline is that Europe's banking crisis has returned and it poses a major risk not only to U.S. equities but also currencies.  We can't see EUR/USD holding 1.12 in light of these troubles but more importantly, central banks who have been looking to ease could look at this unsettling development as a reason to step up easing or slow tightening.  In other words if Europe's troubles escalate, causing U.S. stocks to crash, the Federal Reserve will be less likely to raise interest rates in December even if job growth improves. The Bank of England will increase stimulus and step up its calls to do so if the focus turns to Barclays. Either way, euro and sterling should be negatively affected by Europe's banking crisis.

 

USD/JPY hit a high of 101.84 today on the back of stronger U.S. data before dropping to 101 on the Deutsche Bank news. Second quarter GDP growth was revised higher, jobless claims rose less than expected and the trade deficit narrowed.  Economists had been looking for softer numbers and the good news sent the dollar sharply higher.  While we still like being long USD/JPY, it will be difficult for the pair to hold 101 if Europe's troubles grow. With that in mind, 100.50 or 100.10 may be better levels to come into the currency.  It's the end of the month tomorrow and the month/quarter end flows could help lift USD/JPY.

 

All three commodity currencies ended the day lower against the greenback.  Yesterday's OPEC deal continued to have reverberating effects on the market. After an explosive 5% surge in the price of oil yesterday, oil prices rose another 1%. While investors had some doubt over the actual execution details and subsequent effect the deal would have on the supply, this still marked the first output cut in 8 years. AUD and NZD held up well for most of the session until DB news sent both currencies crashing lower.  Chinese PMI manufacturing numbers are scheduled for release this evening followed by Canadian GDP numbers on Friday.