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The European stock markets have had a delayed reaction to the weak payrolls print out of the US on Friday as they were closed for the Easter holiday. However, as we enter mid-morning stock markets are actually higher. The Dax has broken to a fresh high of the day and even the IBEX 35 (Spain's index) has moved slightly higher this morning.
We don't think this is a sign of a shift in sentiment, instead we believe this morning's recovery is down to taking profit and investors squaring up short positions after a string of losses for European indices. The fundamental back drop is still fairly weak for European equities as austerity bites in the periphery and growth contracts. The ECB failed to offer any more assistance to the banking sector at its meeting last week. While we believe it will eventually act, especially if peripheral bond yields continue to rise, Europe's banking stocks currently look vulnerable.
The problem with Europe's banks
The banking sector of the Eurostoxx index has given back nearly 50% of the up-move from November to the mid-March high. This is important since it suggests that the pullback of the last month is more than just some profit taking and instead highlights real concern on the part of investors about the health of Europe's banks. Spain's banks are of particular concern and today the governor of the Bank of Spain said that if economic growth continues to fall then banks may require more capital. This follows alarming newspaper reports about the lengths some Iberian banks are going to get rid of bad real estate loans on their books. This is reminiscent of 2007-2009 in the US banking sector as it tried to deal with the crippling amount of bad real estate loans on its books. The US banking sector has come out the other side but some institutions are mere shadows of their former selves.
The problem for Europe is that banks and sovereigns share a symbiotic relationship, so when the banks are weak so are the sovereigns and vice versa. After the ECB's LTRO loans we know that Spanish banks upped their purchases of sovereign debt by about 30%. However, as we have said before, banks are in a precarious position in Europe and many may have parked their money in sovereign debt with plans to remove it later this year or next to help fund themselves. Thus, LTRO-funded purchases of sovereign debt are not a reliable or stable source of demand for the debt of Europe's weakest nations. With the growth outlook looking particularly weak, especially for Spain, it is hard to see the broader market work up an appetite for this debt, which leaves an important question unanswered: who will buy the tidal wave of European government debt coming to market this year and next? While growth continues to disappoint and concerns about the banks increase, the odds are increasing that Spain may require a bailout at some stage this year.
France vs. Germany
It is fairly quiet on the economic data front during the European session today. French industrial and manufacturing production for February was the highlight along with German exports and imports. German data surprised to the upside, while manufacturing data out of France was extremely weak, falling 1.2% on the month, which dragged the annual rate to -3.7% from -1.7% year on year. This is another reminder that growth concerns aren't only concentrated in the periphery.
Germany is by far the strongest economy in Europe while France's weak growth outlook, Presidential elections and high debt levels leave it vulnerable in the current environment. The boost to German exports in February, which grew by 1.6% on the month defying expectations of a 1.2% fall, were due to demand for German-made goods from outside of Europe. We continue to think that Germany will do well and thus look for the German Dax to outperform the French Cac index. French borrowing costs have also risen versus their German counterparts, and Paris pays 1.29% more to borrow for 10-years than Germany does. That is the widest spread since January 2012.
The euro continues to trade in its short term range between 1.3040 and 1.3150.However, the failure to break above 1.3150 suggests to us that the bears have the upper hand and we believe a move to test the key psychological support level of 1.30 is now on the cards. The only thing that could stop a breach of this level in our opinion would be intervention by a central bank. All eyes are now on central banks to see whether they react to 1, the weak US payrolls data and 2, the heightened sovereign concerns in the currency bloc. Over the last 4 years central banks have always pumped more money into the financial system when the markets have got rough. We believe they will do so again. However, right now the situation is not bad enough to prompt them to take action. We believe we would need to see Spanish bond yields rise by another 100 basis points towards 7% before the EU authorities and the ECB are forced to take action.
The BOJ kept rates on hold today and did not expand its asset purchase programme. However, it is now expected to increase its APP when it next meets at the end of this month. The weak payrolls and risk-off tone to the market has fuelled safe haven flows into US Treasuries, pushing yields lower and weighing on USDJPY. The next support level of note is 81.00 and below here 80.80. If we fall below 79.91 - the top of the Ichimoku cloud - then that suggests the end of the recent up-trend. For that to happen we believe we would need 1, more safe haven flows into the yen and a risk-off tone to the markets to dominate and 2, a commitment of action from the Fed to act (and provide more stimulus) If the economic data out of the US follows March payrolls and starts to weaken.
As we start a new week the markets are in risk-off mode, the euro looks vulnerable and bond yields in the periphery are rising. Later this month there are elections in France and Greece which could keep markets on edge for the medium-term.
Kathleen Brooks| Research Director UK EMEA | FOREX.com
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