Risk Focus Back To Europe

Written by James Harte

Having migrated away from Europe shortly after Brexit,  G10 currency shifted toward the JPY and the BOJ. However, this week focus has now moved back to Europe, specifically on European banking sector risks.

The risk stems from the dire situation that Deutsche Bank finds itself in. The bank is potentially facing a $14bln fine from US regulators relating to the bank’s mis-selling of US mortgages. Analysts are concerned about the level of the bank’s capital adequacy should they have to settle for such a large figure, this has driven significant bearish movement in the bank’s share price, further weakening their position.

Deutsche Bank Shares Down 50% YTD

The bank’s share price fell below key structural support on Monday on reports over the weekend that the German government had ruled out a bailout deal for their largest bank. However, the price was able to recover slightly off lows mid-week as reports emerged that the government was in fact putting an emergency rescue deal together to be used as a last resort. The plan includes the government taking a 25% stake in the bank in a worst case scenario

There is still a lot of uncertainty around the plan however as the German finance ministry came out to deny the newspaper reports as false. However, the newspaper then countered saying that regardless of the finance ministry’s denial, the plans were, in fact, being prepared and would be triggered if Deutsche Bank is unable to pay the fines.

For now, the price has found the support of the lower trendline of a potential falling wedge pattern with 11.59 providing key short-term resistance.

The uncertainty has fuelled volatility in EUR swaps markets with the EUR  3M basis swap extending to its widest level of the year. However, the swap still remains far off the levels seen during 2008 and 2012.  Typically, banking sector crises and a widening basis swap would have led to a sharply lower EUR, but for now, EUR remains stable.

What Is Keeping EUR stable?

There are a few likely reasons why EUR is holding up despite this fresh concern for the European banking sector

  • ECB Liquidity

In contrast to 2012, there are a wide range of operations and systems in play to provide support for the wider economy through easy access to liquidity such as OMT, TLTRO, and QE. Alongside this, we have factors such as negative rates and excess deposits providing support also.  Notably, the funding requirement for European banks is also much lower than it was in 2012 as a function of the lower operational requirements for USD-funded balance sheets.

  • German policy

Despite the rhetoric, markets are highly sceptical that the German government would actually allow its biggest bank to fail even in the event of significant losses being imposed on shareholders and creditors.  Reports mid-week regarding a rescue deal firm up this line of thinking

  • EUR’s role as a funding currency

Of key importance is the change in the EUR’ risk relationship since 2012. The EuroZone economy now runs a large current account surplus which increases excess liquidity meaning EuroZone investors now typically provide rather than consume capital flow funding on a net basis. This dynamic limits the EuroZone exposure to periods of risk-aversion and furthermore, acute situations that fuel repatriations tend to prove supportive for the single currency.

With these factors taken into consideration, it seems reasonable to expect EUR to continue to stabilise here with downside likely limited. The single currency is further supported currently due to the downshift in US rate hike expectations on the back of the September FOMC.  Traders will now be keen to hear the ECB’s latest assessment and outlook in a few weeks time.