European banking problems likely to weigh on EUR/USD

The following article is courtesy of Marshall Gitler, Head of Investment Research for FXPRIMUS.



The market is starting to get worried about the global financial system again. In particular, the European banking system is worrying people considerably.

Since the beginning of last year, European bank stocks have done even worse than the oil & gas sector, which is saying quite a lot.


US banks have underperformed the US market too, but European banks have underperformed their market even more. European banks have underperformed US banks as well.


One measure of the perceived risk in a banking system is the spread between LIBOR and the overnight index swap (OIS). LIBOR is the rate at which banks lend to each other, so it prices in the credit risk of banks, while the OIS is the rate at which banks can borrow from the central bank and is therefore considered risk-free. The LIBOR-OIS spread has widened out for both Europe and the US, but considerably more for Europe. Having said that, it’s still well below where it was in the crisis days of 2011/2012, so we are not (yet) at crisis levels Europe-wide.


The European banking problem is centered in Italy, where there are concerns about the high proportion of nonperforming loans, estimated at nearly 18% of total loans or some 30% of the Eurozone’s total bad loans. The country recently reached an agreement with the EU on creating a “bad bank” to handle these loans, but there are doubts about whether the agreement can be implemented. The issue is particularly important for Italy, because Italian companies rely on bank loans rather than bonds for most of their financing (about 85% of outstanding debt). Without a solution to the bad loan problem, it will be difficult for the Italian economy to recover.


Having said that, financial stocks in Spain, Portugal and Greece have done even worse than those in Italy. Greek bank stocks are down around 50% just this year alone! Remember that even if a stock has fallen to just 2 cents, it can still fall 50% to 1 cent.


The FX implications of this problem favor the dollar. The ECB will have to intensify its efforts to ease financial conditions, which have been tightening recently despite its best efforts.


Of course conditions in the US have been tightening too, as New York Fed President William Dudley pointed out recently. However, this is a reason for the Fed to stand pat, not to begin easing again. That different response should revive the “monetary policy divergence” theme somewhat and send EUR/USD back towards 1.08, the bottom of its recent trading range, in my view.

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European banking problems likely to weigh on EUR/USD


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