Equity markets started on a positive note, after fabulous earnings released after the bell yesterday by Apple Corp. The positive vibe was wiped away while Ben Bernanke was testifying infront of congress. Market participants were interested in hearing about specific actions that would occur to boost the US economy, and unfortunately the testimony lacked details. The S&P 500 dropped 14 points to 1069.
The European bank stress test leaks continue into feed into concerns about their robustness. According to a leaked document, the tests will describe three scenarios: one under benchmark assumptions, one with an adverse scenario, and one that includes a “sovereign shock.” Clearly, this will be the scenario that garners the most attention by the markets.
Despite the relative calm seen in the periphery this past month, CDS prices and bond spreads are still pricing in significant default risk in Greece and others in the periphery. What sort of recovery rate will the sovereign shock scenario assume? Back in early July, some reports suggested that the stress tests included an assumed 17% loss on Greek bonds. Adding to the confusion, the FT reported today that a Greek haircut of 23% was being assumed. Bankers were quoted by the FT as saying the impact of those haircuts was likely to be inconsequential because they would be applied only to bonds held in banks’ trading books. Banking analysts believe that most Greek sovereign debt is now being held not in trading books but in banking books, where they are designed to be held to maturity. Accounting rules allow banks to shift holdings between these two books, and so the picture could get quite muddied and could be another potential flashpoint for the markets on Friday. Putting which books are affected aside for now (which is a big problem in itself), haircuts of either 17% or 23% both seem too modest. Greece pays 775 bp more than Germany on 10-year bonds, and back of the envelope calculations suggest a much greater haircut being priced. Germany and Portugal bond auctions went poorly today. This may have been due to some market fatigue after yesterday’s heavy issuance schedule by Greece, Spain, and Ireland, but it may also reflect some adjustment in market expectations regarding the stress test results. These leaks are causing unusual trepidation and clearly that is weighing on the Euro.