Banks better capitalized, no liquidity issues

Credit market indicators of European systemic risk appear to have inflected as well. Since widening last week to levels not seen since the Euro crisis in 2011-2012, the cost of credit protection as measured by the iTraxx index for European Senior Financials fell by 8bp for the second day in a row (to a spread of 123bp from 139bp last Thursday).

In our view, the repricing of systemic risk was overdone (and the rally has further to run). Owing to higher capital levels for banks as well as the new backstop facilities such as the LTRO, T-LTRO and ELA, we do not think the recent capital-raising pressures on banks are likely to cause the sort of short-term funding pressures they caused during the European sovereign crisis.

...For one, banks are better capitalized, and have far better access to liquidity and short-term funding. Consistent with this view, the recent pressures on bank credit spreads are not particularly visible in the availability or pricing of short-term funding spreads. Rather, the repricing is primarily visible in equities, capital securities and senior bonds. In other words, we have seen an increase in the cost of long-term capital, including a repricing of senior credit risk, but with confidence that banks have access to short-term funding. Pressures on long-term capital costs are evidently rising, but the secure access to short-term funding renders these pressures less systemic.

A second reason for pushing back on systemic fear goes to the source of these concerns in the first place, namely, growth.We think the growth outlook is better than many market participants appear to believe, and in contrast to those who think recession is imminent, our estimates of the year-ahead risk are only slightly higher than average (in a range of 15-20%; We therefore think that the recent rally in yields will struggle to sustain itself. Indeed, our economic surprise ('MAP') index for the US has been rising for most of 2016, and we think rising wages can sustain consumption growth and housing demand while a more expansionary fiscal policy and favorable inventory cycle should outweigh global headwinds.

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