London Session: Anyone Sick of Europe Yet?

Although Europe is still front and stage most people are sick of thinking about it. The saga has dragged on so long that even though we know that the conclusion of tomorrow’s EU summit will determine market sentiment for the near-to-medium term, today there are other things the markets can rally on.

Firstly, Deutsche Bank and UBS reported earnings that surpassed market expectations. So Europe’s banking sector is not on its knees, right? Not necessarily, but DB has strong retail banking and asset management sections that are making up the shortfall from the trading department in the bank and its EUR228m loss from its exposure to Greek debt. Added to that, DB is already writing down the value of its Greek bonds to just 46% of their notional value, suggesting that the bank is getting ready for an extension to private sector haircuts on Greek debt currently being negotiated by EU officials. Reports say the EU may announce haircuts of 60% of their total value, although we need to wait until Wednesday to hear if they will be voluntary or enforced. Added to this, Deutsche Bank’s core tier 1 capital ratio (the capital buffer necessary to protect Europe’s banks from the worst of the sovereign crisis) is extremely high at more than 10%, and above EU banking regulators’ requirements.

UBS wasn’t such a bright story; however profit declined less than expected and a rogue trading loss was easily covered by profits elsewhere in the bank. Good news is fairly thin on the ground for Europe’s banks right now, and the Eurostoxx banking index is higher on the back of the results today. The risk is that other banks, particularly in France, are not in as good shape as Deutsche Bank and may not be in a position to take such large haircuts without state or pan-European support.

The other bit of good news was for the UK Economy. The current account deficit narrowed significantly in the second quarter, it came in at GBP2.0BN, beating consensus of GBP9.0bn. The improvement was mainly as a result of service sector exports and income accounts (from UK investments abroad). The service sector trade surplus reached a record high in the three months to June at GBP17.8bn; however the overall trade deficit was worse than expected and was at its widest level since the end of 2010. Although this is positive news, it suggests that the government’s aim to re-balance the UK’s economy towards manufacturing and away from services is failing miserably.

The pound has been one of the big winners in the FX world this week. GBPUSD surged to 1.6020 earlier, the highest level since early September, as it continues to benefit from dollar weakness. Testimony from Bank of England Governor Mervyn King to the Treasury today had relatively little impact on the pound, which is being moved about by risk sentiment. Deputy Governor Bean reiterated that the effect of GBP75bn of QE should be a 0.5% boost to GDP and a 0.5% boost to inflation. The two Bank officials also had to explain how they would withdraw stimulus and that more QE would not be inflationary since prices are expected to drop sharply next year.

The dollar is under intense pressure today and is testing support at 76.00 – the 50% retracement of the May low to early Oct high. This is boosting the euro and other risk currencies and the Aussie is sharply higher this week after breaking above 1.0400 and a cluster of daily moving averages that acted as key resistance levels. We still think we are in a buy-on-dips mode, as the latest speculative positioning data suggests that the market is still short euro, so we continue to be witnessing short-covering.

But, back to Europe. We continue to wait for the conclusion of tomorrow’s summit to fill in the blanks, however, the news today is that: 1, Greek debt haircuts could be in the region of 60%, although most banks want 40% max (apart from DB of course). Added to that, Merkel is presenting the German Parliament with an option to leverage the EFSF to EUR1 trillion, which the Bundestag will vote on on Wednesday before the summit, which begins at 1700 BST. The German Economics minister said that Merkel’s coalition should get a majority in tomorrow’s EFSF vote, which added more fuel to the risk rally.

There are multiple EU officials talking today, the most interesting headlines were from Austrian finance minister Fekter who said that “Greece can’t cost considerably more” – is that a question or a statement? She also confirmed that the EU has to decide on two leveraging options for the EFSF. The other interesting headline was regarding the ECB. The EU official said that the summit will seek an “ECB bond pledge at tomorrow’s summit” while simultaneously respecting its independence. The two seem mutually exclusive to me, but perhaps the central bank won’t be able to return to its traditional role as soon as we thought.

Ahead today, US house price data and the Canadian rate decision are the two most important data points of note. The BOC is expected to keep rates on hold at 1%. Canada’s economy is sensitive to global demand issues, so a weak Europe and a patchy US recovery mean that keeping rates on hold is the most expedient solution for Canada right now.