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Daily Agenda: Are European Banks Failing the Test?

ECB data for bank loans disappointed in the wake of stress test results. The question is whether bond purchase data will bring better news.

European bank stress test results have dominated headlines the past two days. While most of the banks that failed had already shored up capital by the time the report was published, some analysts also noted that banks were allowed to count instruments as reserves that will be ineligible as new rules come into effect next year. Société Générale currency strategist Kit Juckes summed up the situation by saying, “From a macro point of view, it was largely a nonevent that allows us to move on to bigger issues.” One such issue is private sector lending data for September, which, while better than forecast, still registered a year-over-year contraction, leading Juckes to ask “is a trickle of credit finding its way through a damaged pipe a source of relief or a reminder of how poor our expectations are now?” This raises a bigger question: how effective can European Central Bank intervention in markets be if the region’s banks stay focused on raising capital levels rather than lending to the business sector? With ECB president Mario Draghi set to reveal the full extent of covered bond purchases in markets last week at 10:30 a.m. New York time, investors will gauge what impact these interventions are really having on the private sector in the absence of political action to complement monetary policy.

German business sentiment in Germany continues to worsen. In Germany IFO business sentiment indexes for October released this morning registered the sixth consecutive monthly contraction. At 103.2 the headline business climate index reached the lowest level since late 2012, while industrial specific data was particularly downbeat suggesting a recent uptick in some indicators for the nation may not indicate a bottom for factory activity.

Corporate profits reporting season plows on. Pharmaceutical giant Merck & Co. reported lower-than-anticipated revenues for the third quarter this morning on lower sales of the firm’s cervical cancer vaccine Gardasil but still posted higher-than-forecast earnings, excluding special items. Amgen will also provide more input for pharma and biotech sector investors when the company reports quarterly results after U.S. markets close today.

Rousseff wins again in Brazil. Brazilian equity markets declined in off-session and nondomestic trading in response to incumbent Dilma Rousseff’s narrow victory in the country’s presidential election held over the weekend. The defeat of contender Aécio Neves, perceived as a probusiness candidate, leads many analysts to conclude that the nation will not make significant progress toward a more market-oriented economy in the coming years.

Russia issues draft budget. The Duma released a draft budget for 2015 to 2017 on Friday that outlines projected Russian government finances. Analysts immediately raised questions about the likelihood that goals could be met based on projections of an average price of $100 per barrel for oil exports, significantly higher than current prices.

Portfolio Perspective: Opportunities in Rates and Forex VolatilityAmrut Nashikkar, Barclays

A long period of quiescent financial markets appears to have ended, with volatility increasing in many asset classes as we approach the end of 2014. Weak economic data in Europe and emerging markets, along with a reaction function from the U.S. Federal Reserve and the Bank of England that suddenly appears more uncertain, have led to volatility in a number of asset classes. The rise in equity volatility has been the most pronounced, followed by that in commodities. Within foreign exchange, while G-10 forex volatilities have largely come off their September 2014 highs, emerging-markets forex volatilities continue to hover at elevated levels. Across assets, the rise in interest rate volatility has been the smallest.

This year, most consensus trades have underperformed, and the recent episode of volatility in risk assets leaves the market at an inflection point. Europe is already experiencing both disinflation and another slowdown. Will the U.S. and U.K. economies continue their moderate pace of growth, diverging from Europe as most expect? Or will the slowdown abroad drag the U.S. data lower, putting into question any lift-off from the zero lower bound? Even with moderate growth, will inflation pressures remain subdued, as the recent sharp decline in medium-term break-evens suggests?

What changed over the past month? Policy uncertainty has picked up. Concerns echoed by various central bankers have caused the market to become uncertain about the date of lift-off in the U.S. and U.K. Despite a worsening economic backdrop in Europe, the prospects and timing for ECB quantitative easing remain unclear. Shrinking dealer balance sheets are also likely having an inordinate effect on the structural liquidity available to investors, as recent price action in the bond markets indicates. Risk aversion has also likely risen, as suggested by the flight to quality in U.S. Treasuries and German bunds, boosting demand for downside protection.

Amrut Nashikkar is a vice president in rates and forex research at Barclays in New York. This is an excerpt from a larger report issued this morning by Nashikkar’s team.

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