European bank rebound in the hands of the ECB

High hopes

European bank investors aren’t waiting around. The sector has risen 8% this week on anticipation the ECB will signal, perhaps today, that the end of the region’s low rates era is nigh.

The central bank is notoriously difficult to read though, and the rebound of lenders’ shares could reverse if the ECB’s statement has surprises that markets interpret negatively.

Bank shares are also recouping from anxieties over Italy’s referendum. That’s despite continuing uncertainty over what Italy will do to prop up its now infamous lender, Banca Monte dei Paschi di Siena (BMPS). Again, it looks like the ECB will indirectly assist. Monte Paschi has asked the ECB to extend the deadline for completion of its rescue to 20th January, from the end of this year. There’s little reason to believe the ECB will turn the request down. And the central bank is also widely expected to take the opportunity offered by a rise in bond yields to extend its asset buying programme past the current March completion date. Higher yields make more bonds eligible for inclusion in the ECB’s €80bn a month purchases. And more bond buying helps Europe’s economy, including Italy, especially right now.

That explains a 12% relief rally of Monte Paschi’s shares over the last two sessions, and why Italian 10-year yields fell back to a three-week low on Wednesday. The bank and is hoping the ECB’s moves will buy more time for a rescue. With an earlier institutional fix off the table due to government collapse, the state has made it known that it is focusing on a €2bn bail-out via junior bonds held by retail investors, whilst the Treasury denies it’s planning to ask the EU’s emergency rescue scheme for a loan. Either way, sharp price moves on the upside invite renewed volatility on the downside if the mood among EU authorities, and markets, hardens.

Two Tuscans

The matter of Italy’s government is also very much unsettled: Prime Minister Renzi can’t wait to exit stage left. Like much else in Italian politics and finance though, his exit, formally announced on Wednesday, isn’t clear cut. For one thing, the head of state immediately appointed Renzi caretaker. And Renzi later acknowledged elections hinge on a court hearing on electoral law due on 24th January. Parties will have to wait, “then vote with the current law as modified by the Court”, he said. It sounded like he was reminding rivals, and voters, of obstacles in the way of early elections, while trying to stay credible by beating a hasty retreat—for now. He also knows any new government needs his Democratic Party’s, backing, as the DP has the most MPs.

Overall, Italy, like its third-largest bank, is still some distance from certainty, and that’s why we are wary that the relief rally in European bank stocks may have run further than is warranted by the still hazardous fundamental outlook.

In that respect, it will be crucial to see whether the ECB also today gives a strong signal about the timing of when extraordinary measures—including negative rates—will end. For Europe’s stronger banks, increased borrowing costs will go a long way towards providing more sustainable relief for their stocks. Shareholders will certainly applaud an end to years of pressure on net interest margins, but what about if the ECB disappoints?

Among City Index clients—Barclays, HSBC, StanChart and Deutsche—are the European sector proxies. Traders have correctly perceived that the three UK-listed lenders have better prospects due to significant overseas revenues, and some of the strongest capital buffers. But the best share price performer over a month is Deutsche Bank, rising 36%, behind Barclays’ 27%, and more modest single-digit rises for HSBC and StanChart. DB’s surge looks the least credible, whilst the DoJ’s sword of Damocles continues to overhang it. But we would expect all of these bank stocks to give back some ground if the ECB falls short of optimistic expectations.