Concerns Over European Sovereign Crisis Ebbed, Stress Tests In Focus

While broad market sentiment remains volatile as driven by economic data released in the US and China, as well as mixed corporate earnings results, concerns about sovereign crisis in the Eurozone has eased in recently weeks as banks requested lower amount of money from ECB's LTRO after the 12-month LTRO expired on June 30.

Over the past week, bond auctions in Greece and Spain were well-received. Spain, which is to repay 24.7B euro of debts this month, raised 3B euro from the offering of 15-year bonds at an average yield of 5.116% on July 15. Compared with a sale of the same similar securities in April, the yield was higher but the bid-to-cover ratio also increased to 2.57 from 1.79.

Earlier in the week, Portugal sold 1.68B euro of bonds due in 2012 and 2019 as average yields of 3.159% and 5.304% respectively while Greece sold 26-week notes at an interest rate below the 5% charged by the European Union for its rescue package.

Encouraging auctions results indicate investors are increasingly confident that peripheral European countries will be able to repay the debts.

As we see from the table below, 2-year peripheral European bond yields generally rose relative to their German counterparts.

Spain's 2-year bond yield fell -44 bps 2.168% last week, narrowing the spread with 2-year German notes down to 139 bps. At the same time, Portugal's 2-year bond yield also slid and narrowed spread with corresponding German Bunds despite Moody's downgrade of the country's credit rating by 2 notches to Aa1. However, Greek bond yields still show elevated concern about a default with the 2-year yield rising +18.7 bps to 10.04%, the highest level in July.

Focus of this week is European bank stress tests which will be released after European close Friday. Euro's recent strength indicates the market generally expects the test to show favorable results for most lenders. The consensus is that the tests should not reveal major problems in big banks but some smaller banks will need to be recapitalized.

The stress tests, conducted by central banks and coordinated by the Committee of European Banking Supervisors (CEBS), include a total of 91 of the biggest banks, representing 65% of the European industry.

The exercise is being conducted on a bank-by-bank basis using commonly agreed macro-economic scenarios (baseline and adverse) for 2010 and 2011. The macro-economic scenarios include a set of key macro-economic variables (eg: the evolution of GDP, of unemployment and of the consumer price index), differentiated for EU Member States, the rest of the EEA countries and the US. The exercise also envisages adverse conditions in financial markets and a shock on interest rates to capture an increase in risk premia linked to deterioration in the EU government bond markets.

On aggregate, the adverse scenario assumes a 3% deviation of GDP for the EU compared to the European Commission's forecasts over the two-year time horizon.

The sovereign risk shock in the EU represents a deterioration of market conditions as compared to the situation observed in early May 2010.

According to the press, the minimum solvency level is a tier 1 capital ratio of 6%. However, there are still many uncertainties including the scale of haircut on government bonds (the press said that the haircuts on Greek and Spanish government bonds will be 17% and 3% respectively), how long banks will need to raise funds and whether the 440B euro EFSF will be used to recapitalize banks.

Impacts of the test on currencies are various. As the market has priced in generally positive test results, worse-than-expect outcomes should hurt the euro as well as other European currencies. However, if more banks passed the tests and the tests are found transparent enough to restore market confidence, the magnitude of euro's downside can be significantly reduced