Concern Over The EUs Bank Stress Test Grows

News and Events:

Markets gained a temporary sense of optimism as FX risk-correlated trades recover from yesterday's sell off and equity markets rally in Asia. Yesterday we saw a sharp reversal - especially in the EURUSD as leveraged players cut their long positions after the pair lost momentum and seemed to run into resistance. EU officials are on the wires talking up the bank stress test due to be released this Friday.

As we've already stated this week, we suspected that EU officials would throw a few sick banks under the bus in an effort to create the illusion of rigor. Greek, Spanish and now French officials have all been vocal affirming that the vast majority of their banks will pass the test. French Economic Minister Christine Lagarde stated she was 'confident' about the results of the stress test for French banks, but failed to provide any details as to why.

The show boating is making us a bit concerned about the 'stressfulness' of their methodology. Our best guess is that the test will measure the two major types of bond portfolios within banks. One bond type is used for trading which the ECB can apply a haircut to, the second is your traditional hold-to-maturity bonds which are going to be mark-to-market and potentially deemed immaterial. EU offical move in this direction since they are concerned with a 'trading shock' more then a default. However, we hearing rumors that there's been a fascinating migration of tradable bonds into the hold-to-maturity classification as of late.

The EU structured safe haven for these bonds and not looking at the full picture concerns us as it is a convenient place to hide bad assets and tell half the story. We don't believe that this stress test will provide the confidence the market is searching for and certainly not be as successful as the US stress test. We suspect that the EUR will continue to come under selling pressure and we are watching for a test of the 1.2750 lvl.

In Japan, the BoJ minutes released this morning asserted the central bank's commitment to 'continues to aim at maintaining the extremely accommodative financial environment' and that the BoJ's new scheme to encourage commercial lending to growth industries would be initiated in August. Perhaps the most intriguing aspect is that officials continue to make comments on the recent Yen strength while BoJ Deputy Governor Yamaguchi reiterated that they are watching forex moves very carefully.

While we don't expect US yields to reverse their current direction, which would provide a great catalyst for a JPY sell-off, we do believe that Japanese comments and potential intervention around the 85 lvl will provide some ample USDJPY buying opportunities in the near-to-mid term.

Today's focus will be on the BoE's MPC minutes release & Chairman Bernanke's testimony to Congress. MPC member Sentance voted for a rate hike at the June meeting and his recent public comments continue to be hawkish. However, dovish MPC member Posen maintained to Dow Jones that there was more than a 50% probability that the next BoE move would be a policy loosening, not tightening. Sterling has been very jumpy as of late as traders try to anticipate the BoE's next move. Without any clear guidance, this is a currency we would avoid for the time being.

Today Key Issues:

• 08:30 GBP retail sales, +0.5% m/m, +1.0% y/y eyed; last +0.6%, +2.2%.
• 08:30 GBP BoE MPC minutes, vote 7-1 prior
• 09:30 EUR German FinMin Schaeuble, French FinMin Lagarde meeting in Paris.
• 10:00 EUR Germany E4.0 bln 3.25% 2042 Bund auction.
• 00:00 EUR Portugal E1.25 bln 12-month Treasury bill auction.
• 10:15 EUR Schaeuble-Lagarde, Franco-German Econ-Fin"l Council press conference.
• 18:00 USD FOMC Chair Bernanke semi-annual Senate testimony

The Risk Today:

EurUsd Just as we suspected in yesterday's report, the brief visit above 1.3000 (1.3028 the high) soon attracted the attention of bears who re-emerged in numbers and drove the pair all the way back down to lows of 1.2839. We feel that at these lofty levels, a short bias seems the most attractive in terms of risk-reward (recall that the rally to 1.3028 represented a 9.5% appreciation in the space of just 6 weeks), and significant resistance level appear to cap the upside to 1.3095-1.3125. That zone of anticipated selling interest includes the triple whammy of 10 May high (1.3095), the 4-week uptrend channel resistance at 1.3115, and also the 38.2% fibonacci retracement of the entire sell-off from 1.5145 to 1.1876 which comes in at 1.3125. The tricky part here is selecting favourable entry levels and a small enough position size to tolerate a wide stop; 1.2950 would be the ideal area for us to re-load shorts, with the view that the pair should at the very least re-visit the lower edge of this 4-week uptrend channel in the coming days (currently seen at 1.2745). We still expect some buyers to lie around 1.2780 (a former pivot) and 1.2683 (last Wednesday's low).

GbpUsd The fickle short-term trends in GBPUSD are making trading conditions difficult, and indeed the 1-week downtrend channel we highlighted yesterday morning has already broken its originally defined ceiling -a development made all the more frustrating by the fact it came very shortly after the pair had broken through 1.5230 support (which would have suggested in our minds that the next significant leg of this move would be to the downside). Given this whipsaw action, we prefer to steer clear of fresh trade entry for the time being, and should the bulls clear the next significant resistance at 1.5350 (19 Jul high), we could be induced to consider longs once more. Above there the likely targets are 1.5472 (last Thursday's high), and 1.5525 (15 Apr high). Should the pair opt to go lower instead, yesterday's low was 1.5154, and next supports are seen at 1.5080 former neckline, 100-day moving average 1.4992, then the 12 Jul low 1.4949.

UsdJpy A very interesting picture for USDJPY at the moment with the possibility of both a bullish triangle pattern and a bearish flag pattern currently on the table. Yesterday we highlighted an ascending triangle pattern on the hourly chart with a target at 88.15 which looks to have been activated by the move up through 87.22; but having assessed the subsequent price action, it looks more accurately like this was in fact a symmetrical triangle. The consequences of this shift in definition is a mere 5 pips (the target now 88.20), so our view of the topside prospects remain unaltered;resistance is seen around 88.00 (i.e. might use discretion on taking profit a little earlier than the pattern's defined target), and further supply remains at 89.15 (12 Jul high) and 89.50 (28-29 Jun high). What is intriguing however about the current picture is that there is also the possibility of a bearish flag coming into play in the coming sessions, and which currently suggests a break below 86.95 (lower edge of the flag) would be a good trigger for short entry -implying a target of 84.20 below. This bearish scenario does tie in nicely with the recent break of 86.97 (1 Jul low) which opened up the possibility of another plunge towards Nov 2009 lows of 84.83; but once again we should remain cautious that such a bearish target would almost certainly catch the attention of the BoJ in which case intervention may be a very real and ruthless threat.

UsdChf The 3-week downtrend channel continues to direct price action in the short term, but trendline resistance has already been under threat this morning around 1.0515. Given that the bears looked unable to muster a decent assault on 1.0400 at the end of last week, they are likely to capitulate soon enough in defending this trendline too. Having said that, it doesn't look like the bulls are all that feisty for a move higher either, so perhaps we will be confined to ranges for the time being. If that's the case, we think that current levels (1.0530) actually look pretty attractive for short entry given the previous price action around 1.0550-60. We'd be satisfied using 1.0580 as our stop, and set a first target on the downside of 1.0450 (Monday's low), with 1.0400 (double bottom seen last week) as a possible extended target. Some bulls may favour buying on the dips towards, 1.0400, but should they be wrong the landscape below 1.0400 is only dotted with stale support levels at 1.0365, 1.0315 (trendline support), then 1.0230 -could be a nasty plunge with few buyers to slow the descent.