The Dirt on Stress Tests

A stronger than expected German Ifo confidence survey this morning (106.8 vs. 101.5) is supporting the EUR ahead of the Bank Stress Test releases. Along for the ride is Sterling aided by its 2nd Q GDP print (+1.1% vs. +0.3%). Market sentiment has been on a high since the release of improved economic data out of the Euro-zone and US yesterday. A string of strong earnings is boosting the hope of a global recovery. But, will the Stress Tests be transparent and stringent enough to appease the markets appetite for wanting to apply more risk? The results are available at noon. Different scenarios will be considered, a base case and an adverse economic scenario, which includes and excludes assumptions about sovereign debt haircuts (haircuts are expected to be in a range of 17% on Greek debt, 3% on Spanish bonds and none on German debt). Most concern remains over the treatment of banks’ holdings of sovereign debt. Banks will be required to demonstrate that their Tier 1 capital does not fall below +6%. It is widely expected that banks will also be required to provide evidence of how any necessary capital is to be raised to meet any shortfall. It’s anticipated that 10-20 banks (out of 61) may need to raise new capital (approx. EUR30b), but none of the larger EU banks are expected to be in this category. Initial public reaction will probably want to sell the market and then investors will have to figure if the tests are a ‘beneficial catalyst for change’. Will the tests help overcome the lack of information that has been a recurring problem during the financial and credit crisis?

The US$ is mixed in the O/N trading session. Currently it is lower against 11 of the 16 most actively traded currencies in a ‘whippy’ trading range.

US unemployment insurance claims are reverting back to the ‘bad old days’ of June. Last weeks headline print of +464k happened to drag the series to just below the elevated 4-week moving average witnessed last month. The volatility of the series is expected to continue beyond next week, when by then analysts expect it should to have settled down. So it seems that its odd’s on for at least another rise. State continuing claims fell -223k to +4.487m vs. market expectations of +4.5m, while Federal softened by -368k. Collectively, the decline is explained away in part ‘to benefit exhaustions rather than changes in labor market conditions’. Analysts expect that part of the decline to be ’reflected in the monthly unemployment rate’. It’s worth noting that when individuals exhaust their eligibility, they are likely to report themselves as ’job-wanters’ rather than active ‘job-seekers’. This action will remove them from the traditional unemployment rate measure.

Most analysts continue to see ‘doom and gloom’ in the post US existing home sales surprise yesterday (+5.37m vs. +5.1m, -5.1%). Opinion seem adamant that that the gains will ‘vaporize’ over the remainder of the summer. Many are predicting new record lows as the stampede to buy in Apr. before the homebuyer tax credit expired has increased pending home sales in the 1st Q and directly supporting re-sales ‘since the pending transactions close and show up in re-sales only 30-60 days later for the most part’. We already have witnessed the seasonally adjusted pending home sales plummeting -30% in May and the seasonally adjusted mortgage purchase applications are still -42% lower. Proof is in the pudding, in black and white, record lows are around the corner. Digging deeper, re-sale activity in the single-family home segment was hit the hardest (-5.6%). Condo’s fared a tad better (-1.5%). On average, the re-sale housing market has just less than 6-months of supply, well below the cycle’s high of 11-months. None of this reflects the infamous ‘shadow inventory’ out there.

The USD$ is lower against the EUR +0.01%, GBP +0.32% and higher against CHF -0.08% and JPY -0.01%. The commodity currencies are stronger this morning, CAD +0.39% and AUD +0.21%. Yesterday’s Canadian retail sales was better than the headline suggested (-0.2% vs. +0.5%) for two reasons. Firstly, the dollar value of retail sales ex-autos and gas receipts actually climbed +0.2%. One can assume that it was gas prices that distorted the headline and the core-sales. Secondly, the decline in the dollar value of retail sales was all in price terms, as the volume of sales actually advanced 4bp in May. However, the gains were not that impressive. That been said, Canadian loonie enthusiasts were preferably pre-occupied with Carney and Co.’s MPC report. He enforced that there was no pre-ordained path for interest rates in Canada. Earlier this week, the expected BOC rate hike was followed by a somewhat dovish communiqué. According to Carney ‘the global economic recovery is proceeding, but, is not yet self-sustaining’. This week’s 25bp hike will ‘leave considerable monetary stimulus in place’, with both the core and total inflation to advance at about a +2% annual rate through 2012 (within their target zone). Some will argue that with signs of a significant slowdown underway in the US, it’s possible that the BOC may be persuaded to move back to the sidelines on the Sept. go-around. Carney has given himself the latitude to step back and assess global growth for the 3rd Q. The market will take time out and digest today’s Euro-zone’s stress tests before ‘throwing all in’. Stronger commodity and equity prices favor buying CAD on pull backs.

The AUD traded near its 2-month high this morning as concerns on the bank stress tests faded. The strength of the carry trade is once again encouraging investors to apply the ‘risk-on’ trading strategy. The currency gained +2.7% vs. the greenback this week after the RBA’s July minutes showed that Governor Stevens intends to use results of Europe’s stress tests and local inflation figures, due out next week, to decide whether to resume raising rates. The pace of CPI increased nearly doubled to +0.9% in the first quarter. Fundamental analysts believe it would take another rate hike for the currency to trade again in the 90’s and technically it’s a sell on approaching these levels. The Governor has also indicated that the election, called by PM Gillard, would not impact the Aug. 3 interest-rate decision and that the medium-term picture for Australia is ‘fairly positive’. Policy makers are ‘reinstating their view that domestic growth will be about trend’ and are ‘not alarmed by the global demand backdrop’. In retrospect, policy makers remain ‘very upbeat’. Because of equities actions, the market is a cautious buyer on pullbacks, wary that the recent strong rally technically may be overdone (0.8934).

Crude is little changed in the O/N session ($79.02 down -28c). Crude prices rallied yesterday on the back of a report showing accelerating growth in Europe’s manufacturing and services industries. Investors took this as a sign that demand in the region would rise despite a surprising EIA report earlier this week. The market had been expecting a drawdown on inventories yet again. However, not so, stocks showed a surprise increase, reporting a rise of +400k barrels of oil for the week whilst the market had been expecting a headline decline of -1.6m. The dovish report continued with its gas inventories rising +1.1m barrels and its stockpiles of distillates (diesel and heating oil) doubling expectations to +3.9m barrels. All last week the market was hung up on the growth concerns of the world’s two biggest consumers as China’s economic growth eased and the Fed said that the ‘US outlook had softened’. Once again technically, the gas markets numbers show ‘lackluster demand and will put pressure on the entire energy complex’. We continue to remain range bound with the price action as the market looks for vindication.

All this week we witnessed investors paring their commodity interests amid uncertain markets. The ‘yellow metal’ has constantly been fighting its technical support 100-day moving average. Prices have found it rather difficult to gravitate too far from that $1,185-88 magnet. Dealers expect investors to dump their remaining long positions on a break of this level. Tentatively, gold futures are trying to rebound on speculation that the Fed will act to stimulate US growth. This action should drive the dollar lower and boost the appeal of the precious metal as an alternative asset. At the moment it’s has been frustrating for investors to buy into the intraday story, the ‘too and froing’ of the price action in a tight range has proven expensive this week. A positive equity market, bullied by the seasonal earning’s reports should continue to drag the commodity higher. Bigger picture, technically, the bullish sentiment had been on hiatus with profit taking testing the medium term support levels. Fundamentally, in the short term the metal will find it difficult to rally aggressively, as historically, this is the ‘slowest’ season for physical demand. Despite this, longer term view, market concerns over global economic growth should support the ‘yellow’ metal prices on much deeper pull backs. However, that been said, weaker longs firstly need to be taken out of the market. Year-to-date, the commodity has gained +9.3% and is in danger of giving up more ($1,198 +$3.00).

The Nikkei closed at 9,430 up +210. The DAX index in Europe was at 6,177 up +36; the FTSE (UK) currently is 5,314 up +25. The early call for the open of key US indices is higher. The US 10-year backed up 5bp yesterday (2.95%) and is little changed in the O/N session. After printing new record low yields, the US front-end plunged on higher earnings easing concerns that the Fed may have to consider more stimulus measures to help sustain the US economic recovery. With the Treasury planning to auction $104b of new product next week ($38b 2’s, $37b 5’s and $29b 7’s), cumulatively lower that the previous two months, will certainly have dealers wanting to cheapen the curve a tad at these technically ‘rich’ low–yields. Current market sentiment has dealers wanting to be better buyers on deeper pull backs, as the market foresees a flatter yield curve as analysts predict that 10’s will yield 2.75% by year-end.

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