The European banking system: The key market to focus on next week

Asia is shaping to close the week out on modestly positive footing, with BHP indicated to open up 2% and CBA closer to 0.5%, given the moves in the American Depository Receipt (ADR).

Deutsche Bank
Source: Bloomberg

This was certainly not the case through European trade with our call for the ASX 200 a lowly 5096 (or 1% lower), but US traders have come and turned things around with the S&P 500 rallying 1.4% from its intraday low of 2050. SPI futures (September contract) have rallied in appreciation, as has AUD/USDUSD/JPY and other risk assets – with the exception of oil, which is still 2.9% lower from yesterday’s ASX 200 close.

We still need to see the ASX 200 close 5312 to avoid a third consecutive week of losses, which clearly isn’t going to happen. 

It’s hard to see traders buying the open with any conviction given next week’s event risk, but we could see some brave souls who see a ‘remain’ vote in the UK referendum tempted by adding selective risk to portfolios. I suspect any upside in the index should be contained to 5175. This is a highly risky strategy as next Friday promises to be utter madness and as such, we have heard from the Bank of Japan, Federal Reserve and Swiss National Bank overnight assuring participants that they will provide liquidity should it dry up on the day. 

What I am genuinely interested in though was the five basis point drop in five-year US inflation expectations overnight to 1.51%  – the lowest levels since early March. We see a further dovish twist from the Fed and yet inflation expectations keep falling. The Fed will not like that one bit, although we have seen a slight move higher in nominal US treasuries. Inflation expectations (measured through the bond market) continue to be part of the holy trinity of Fed influences, the others being the UK referendum and the labour market.

Traders would be wise to start to pay greater focus to the European banking sector, where both investment and sub-investment grade credit default swaps (CDS) are once again on the move higher and worryingly eyeing January highs. Bond yield spreads between Southern European countries and German debt are widening and this is a huge negative for European banking system. We need to remember just how exposed European banks are to their domestic bonds (given their exposure on the balance sheet), so if yields rise, the markets’ perception of the asset quality deteriorates. Names like Deutsche and Unicredit will become central to sentiment in all markets if we see a vote to ‘Brexit’ and the hugely overleveraged European banking system could be in trouble. It’s this issue above all others that would be keeping me awake as a consideration for the vote.

On the other hand, if we see a vote to ‘remain’, then these spreads will come in nicely and European markets will absolutely fly. Long Stoxx 50, short S&P 500 will be very compelling trade for traders who are happy to somewhat take the macro out of the equation, given the Stoxx50/S&P 500 ratio has run so far so fast, as we can see from the chart and the line of best fit. Everyone will be focused on FTSE and rightly GBP, but for me the most interesting dynamic will be what happens to European yield spreads and the knock-on effect to the banking system.

This information has been prepared by IG, a trading name of IG Markets Limited. In addition to the disclaimer below, the material on this page does not contain a record of our trading prices, or an offer of, or solicitation for, a transaction in any financial instrument. IG accepts no responsibility for any use that may be made of these comments and for any consequences that result. No representation or warranty is given as to the accuracy or completeness of this information. Consequently any person acting on it does so entirely at their own risk. Any research provided does not have regard to the specific investment objectives, financial situation and needs of any specific person who may receive it. It has not been prepared in accordance with legal requirements designed to promote the independence of investment research and as such is considered to be a marketing communication. Although we are not specifically constrained from dealing ahead of our recommendations we do not seek to take advantage of them before they are provided to our clients.