Draghi is Right, Banking Stress Indicators are Getting Better
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The current market rally has caught many by surprise and many commentators have been left puzzled by events. While many commentators have fretted over the weakening economic situation in Europe –and I promise you I have not listened to a conference call where European conditions were not an early analyst question- and some related softness in the US, the markets have put on quite an impressive run. My major concern is actually China, but that is a subject for another time.
For now, I want to share some banking stress indicators (they update) of which I monitor in order to see how things are progressing. A suggestion would be to bookmark this article and come back to it if you want to do the same. I will explain them but you don’t need to be a banking expert in order to keep an eye on them.
Clearly the stocks most immediately affected will be the banks. In terms of the US banks, Fitch previously released a report which outlined the net exposures and sovereign debt holdings of the leading banks. The three with the biggest net exposure to Europe were Citigroup (NYSE: C), Bank of America (NYSE: BAC) and JPMorgan (NYSE: JPM). Far less exposed were Morgan Stanley (NYSE: MS), Wells Fargo and Goldman Sachs (NYSE: GS). The latter of which has been reported as merrily selling off its holdings in Italian debt in the last quarter. The relatively smaller exposure of the last three should not give too much comfort though. As we learned in 2008, these banks interests are so enmeshed with each other and the financial system that a crisis will leave them all in trouble. If anything, they have gotten more market share since then. So much for the plan to get rid of ‘too big to fail!’
To Draghi or Not to Draghi?
The central question that investors have to answer is whether they believe Mario Draghi and the ECB’s resolution in dealing with the ongoing problems. In his recent speech, he spent a lot of time outlining how much progress he has made in the last six months in dealing with the crisis. So is he right and where are these banking indicators that I mentioned earlier?
The suspicion is that, right now with this rally, this isn’t a widespread ‘risk on’ trade and the market badly needs this. Sentiment needs to turn around with regards to the sustainability of Italian and Spanish bond yields or there will be further turmoil ahead. What is the market telling us?
First, let’s look at Spanish and Italian 10 year bond yields.
The third of the charts I want to look at is the three month Euribor interest rate. This is simply the rate at which banks lend to one another in euros over three months. If the banks were stressed (as they were in 2008) this rate would be high, because the banks would not want to lend to each other.
3 Month Euribor Rate. Down is good.
Next up is the three month euro/US Dollar basis swap rate. Put simply, this represents the premium that European banks will pay to swap euro for dollar funding. Obviously if the European banks fear the worst they will pay more for dollar liquidity.
3 Month euro/USD swap rate. Up is good.
Next up we have the five year euro swap spread. The higher this rate is, the more the perceived risk in the system.
5 year euro swap spread. Down is good.
Progress has been made. I would caution that these levels are still historically a bit high, but nevertheless banking stresses do seem to have been alleviated somewhat according to this measure.
Lastly I want to highlight the recourse to the ECB deposit facility. In plain English, the more this is used, the more banks are likely to be feeling stressed enough to want to park cash at the ECB.
Recourse to the ECB deposit facility. Down is good.
Draghi was right. Banking stress indicators are demonstrating that things have gotten better.
So What Does All This Mean?
I’ll start to answer this by pointing out what it doesn’t mean. It doesn’t mean that Greece isn’t a basket case and may well default. It doesn’t mean that Spain won’t need to go to the IMF for a bailout. It doesn’t mean that European growth is slowing due to necessary austerity measures.
What it does mean is that the euro zone and the ECB have been somewhat successful in alleviating conditions for the banks and the wider economy. Moreover the Europeans are making cuts and structural reforms. They are acting to deal with their imbalances and in the long term this is good news. It is also good news for the US banks that I talked about earlier whose risk discount due to European fears must surely dissipate if current trends persist. It is going to be a long hard slog but most of Europe seems to be pulling in the right direction.
SaintGermain has a long position in Wells Fargo The Motley Fool owns shares of Bank of America, Citigroup Inc , and JPMorgan Chase & Co. Motley Fool newsletter services recommend Goldman Sachs Group. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.If you have questions about this post or the Fool’s blog network, click here for information.