The Stress Test May Relief Market Stress

23 July 2010. That's the fateful day that will prove to the world that the European banks are solvent. I've been reading a lengthy report by Morgan Stanley on the implications of the European stress test. You see, the reason that markets have been falling in the last 3 months is the freezing up of the European banking system. Although the VIX is now below 30, the JP Morgan Non Investment Grade Index is around 803 bps, the LIBOR - OIS spread remained stubbornly high for the last 4 months. While interest rates haver been kept low by ECB, the European banks have not been lending as they were using the cheap funds to repair their balance sheet.

Confidence needs to return to the market before a rally can begin. I think the ECB is determined to prove to the world that their banks are solvent. There are many ways to salvage them. Just borrow the template from the Americans. To prevent a default of any PIIG bond, the ECB must buy up most of the new PIIG bond issues in the next 2 years to prevent defaults. This must be done at below-market-interest rates. Next, ECB must introduce a European version of TARP to recapitalise their banks. Some form of nationalisation may occur, or the ECB may accept preferred shares instead of common shares with voting rights.

So if Europe is not a problem, where else should we worry? China's property bubble is fast deflating. I believe their banking system can withstand a 20 - 40% drop in property prices without causing systemic risk. After all, a typical Chinese pays between 20 - 50% downpayment for their first house. But the fall in wealth will affect their stock market.

Overall, the signs are pointing towards a U-shaped recovery, which is consistent with our stand all along. The 2nd year of the post recession tends to be slower growth, followed by much stronger growth in the 3rd year.

Don't forget, the yield curve spread is still very wide. 3 months UST is less than 0.5% while 10 years is 2.95%. Seldom, if ever does the US economy shrink when the yield curve is positive.

If short term rates are so low, it will only be a matter of time before those funds that have recently fled to money market funds come out of hiding and into risk assets such as property, stocks and commodities. Remember, it's always darkest before dawn.