European Banks Having Trouble in Short Term Funding Markets

While we are seeing the euro climbing higher in the beginning of this week's trading, we still have underlying concerns especially around European banks. This concern was highlighted by IMF Managing Director Lagarde in her speech at Jackson Hole and her call for urgent recapitalization of banks.

This is doubly important as recent weeks have seen European banks finding it more difficult to borrow in the short-term market.

From the Telegraph: Europe's inter-bank market is effectively frozen and EMU banks have lost access to America's $7 trillion (£4.3 trillion) money markets. Lenders have parked €126bn (£112bn) at the European Central Bank for safety rather than risk exposure to peers.

Borrowing costs for European banks are climbing on the back of fears over bank exposure to shaky euro zone sovereign debts. Lenders are balking at providing anything but the shortest maturity funds. The sharp swings in global financial markets have also intensified strains.

Here's a look at the LIBOR-OIS spread, a measure of bank borrowing costs which has soared of late:


Over the past month we have seen European bank share prices coming under extreme pressure as a result. Some of the worst seems to have passed but these problems continue to persist underneath the surface.

IMF's Lagarde's View - Dangerous New Phase, Call for Recapitalization, Don't Choke Off Recovery

width=306In Lagarde's view the European economy is entering a dangerous new phase with the risk being the fragile recovery is derailed. One of her solutions is to have some type of mandatory substantial recapitalization of the banks. At the same time she also questioned the recent ECB rate rises as well as Europe's fiscal austerity drive as it can undercut recovery.

From Bloomberg: Without an urgent recapitalization, we could easily see the further spread of economic weakness to core countries, or even a debilitating liquidity crisis, Lagarde said. Recapitalization should be substantial and a mandatory move would be the most efficient solution, she said

From the Telegraph: Monetary policy should remain highly accommodative, as the risk of recession outweighs the risk of inflation. Fiscal policy must navigate between the twin perils of losing credibility and undercutting recovery, she said.

The market did not have a large reaction to her comments, and we'll see if her call sounds alarmist or not as we move forward in the sovereign debt crisis.

ECB Trichet's View - Liquidity Ample, Fundamentals Sound, Inflation to Remain Above 2%

width=300As a juxtaposition to Lagarde's comments, we did have the ECB president shades give a speech both the Jackson Hole and then in front of the European Parliament.

At his Jackson hole speech Trichet outline that the ECB has been willing to use nonstandard measures, but that those measures have depended on the functioning of the monetary policy transmission and must be commensurate with the level of malfunctioning or disruption of money and financial markets and segments of markets.

He reiterated that the nonstandard measures do not in any way impinge upon the ECB's capacity to deliver price stability in the medium term.

In his speech in front of Parliament he laid out three key points:

  1. Euro area economy continues to grow at a modest pace in a context of overall relatively sound fundamentals for the euro area as a whole, though uncertainty remains particularly high.
  2. He said that monetary liquidity remains ample with the potential to accommodate price pressures, in essence saying that there is no liquidity problem within the euro zone.
  3. He also said that the ECB expects to see inflation remain above the 2% level over the months ahead and that everybody understands that the ECB will maintain a solid anchoring of inflation expectations is decisive-for confidence in general.

Germany Brushes Off Call for Recapitalizaion

<a rel='nofollow' href='{random}' target='_blank'><img src='{random}&n=a135424c' border='0' alt='' /></a>

The German government said that it shares European Central Bank President Jean-Claude Trichet's view on banks' liquidity.

From SFGate: We share Trichet's assessment in principle that the measures taken at European level to stabilize the euro states and to strengthen the resilience of the financial sectors will prevent a liquidity crisis in the European banking sector, Finance Ministry spokeswoman Silke Bruns told reporters in Berlin today. She was responding to a question on whether the government agreed with comments made by Christine Lagarde, the new International Monetary Fund chief, urging a mandatory recapitalization of European banks.

Spain has already taken steps to recapitalize its struggling banking sector.

Italy's Bond Auctions Can Be Crucial to Deciding Fate of EUR

With these two opposing views out there in the marketplace, how yields in the euro zone behave will be a key determinant to the euro's fortunes for this week and throughout September. We're going to have an important test this week as Italy auctions off debt and Spain and France are also planning sales.

From Bloomberg: Italy will auction off 3.75 billion euros ($5.4 billion) of 10-year securities to create a new benchmark, and Italy is marketing 4.25 billion euros of bonds maturing in 2014 and 2018. This auction will be held tomorrow.


The ECB bond buying program has helped to bring yields on Italy 10-year bonds down to around the 5% level,but it is barred from buying directly in the primary market and therefore this auction will be a test of what type of appetite there is for Italy's debt among bond traders.

If bond traders believe that the ECB will continue to commit funds in order to keep Italy's yields in check, then this auction should find good demand. However, if there is concern about the staying power of the ECB in the bond market this becomes a riskier play.

Italy's 10-year bonds trade at about a 3% premium over German bonds currently, which could make them attractive to those in the former camp.


We therefore want to see what type of reaction we get to this week's Italy bond auctions, and how that will affect the euro in this week's trading.  A jump in yields would mean that the euro comes under pressure, while a strong auction can help the euro to extend its move above 1.45 that we saw in today's trading. We also want to continue to monitor the developments in the funding market for European banks, especially for any stress.

For More on the EUR/USD, see today's Technical Update: Lagarde vs Trichet; Italian Bond Auction/Yields to Decide Winner

Nick Nasad

Chief Market Analyst