By Kathy Lien, Managing Director of FX Strategy for BK Asset Management.

The biggest story in the financial markets Thursday was Deutsche Bank (NYSE:DB) amid growing fear that it’s about to become the next Lehman Brothers. In the last 24 hours, shares of DB have fallen more than 7% intraday, the Dow dropped nearly 1% and currencies fell off the bed. Risk aversion permeated the market on reports that the bank’s hedge-fund clients are withdrawing excess cash, lowering collateral on trades and generally reducing exposure to the bank. DB has been plagued with troubles for the past few weeks but as the company’s stock extended its slide, the tension turned into greater risk aversion.

Interestingly enough, the euro was not the hardest-hit currency. In fact it ended the day unchanged against the greenback with its losses paling compared to the slide inAUD/USD, USD/CHF and even GBP/USD. Still, if this was truly a ‘Lehman moment’ for Europe, EUR/USD would be trading much lower. We see only two explanations for the currency’s resilience — German yields are up and U.S. yields are falling. Or, a majority of investors still believes that Deutsche Bank is too big to fail. CEO Cryan argues that the company has tremendous liquidity reserves and raised another $1 billion euros from its sale of Abby Life. But the problem is that DB could owe up to $14 billion to the U.S. Department of Justice, which is charging the company for legal costs and settlements related to their investigation into the bank’s mortgage-backed securities. Investors fear that the expense would cripple the bank financially. At first there was hope that the German government would provide a bailout, but it denied claims that it is preparing a bailout while CEO Cryan said it’s not an option. In response, institutional and retail investors pulled their funds, putting the bank in a greater cash crunch. Deutsche Bank’s fate has significant ramifications for global markets because it has deep connections with financial institutions around the world and many companies will be affected by its insolvency.

The big question, now, is how DB will raise capital as its current focus is on selling off profitable businesses. Unfortunately, the only way to stop this crisis of confidence is for Chancellor Merkel to offer a bailout. The problem is that its politically unpopular and next year is an election year. Merkel has been a vocal opponent of putting taxpayers on the hook for bank bailouts but at some point, the economic consequences could outweigh the political fallout. The only “other way” we see the DB crisis settling is if the bank manages to substantially negotiate down the DoJ’s fine. Of course it’ll probably have to cut bonuses since that could easily save them 1 or 2 billion euros. But the first two options would do a better job of reversing market sentiment. Deutsche Bank’s troubles have also raised concerns about other banks in Europe — Credit Suisse (NYSE:CS) and Barclays (NYSE:BCS) are also in mortgage-settlement talks with the U.S. government.

The bottom line is that Europe’s banking crisis has returned and it poses a major risk — not just to U.S. equities but also currencies. We can’t see EUR/USD holding 1.12 in light of these troubles but more importantly, central banks who have been looking to ease could see this unsettling development as a reason to step up easing or slow tightening. In other words, if Europe’s troubles escalate, causing U.S. stocks to crash, the Federal Reserve will be less likely to raise interest rates in December — even if job growth improves. The Bank of England will increase stimulus and step up its calls to do so if the focus turns to Barclays. Either way, euro and sterling should be negatively affected by Europe’s banking crisis.

USD/JPY hit a high of 101.84 Thursday on the back of stronger U.S. data before dropping to 101 on the Deutsche Bank news. Second-quarter GDP growth was revised higher, jobless claims rose less than expected and the trade deficit narrowed. Economists had been looking for softer numbers and the good news sent the dollar sharply higher. While we still like being long USD/JPY, it will be difficult for the pair to hold 101 if Europe’s troubles grow. With that in mind, 100.50 or 100.10 may be better levels to come into the currency. It’s the end of the month on Friday and the month/quarter-end flows could help lift USD/JPY.

All three commodity currencies ended the day lower against the greenback.Wednesday’s OPEC deal continued to have reverberating effects on the market. After an explosive 5% surge in the price of oil on Wednesday, oil prices rose another 1%. While investors had some doubt over the actual execution details and subsequent effect the deal would have on supply, the deal still marked the first output cut in 8 years. AUD and NZD held up well for most of the session until DB news sent both currencies crashing lower. Chinese PMI manufacturing numbers were due Thursday evening followed by Canada’s GDP numbers on Friday.

Source: Investing.com

Click To Join Our Community Telegram Group