ForexSpace.com - Calm trading in the wake of Europe’s long Easter looks set to continue. Nonetheless, as we trudge back to our forex news desks after a welcome holiday from euro zone debt woes, it’s clear the break has done little to improve the mood. In fact, it just got worse! Sentix research group has just published its research findings that investor sentiment across the single currency bloc dropped to -14.7 from -8.2 in March after three consecutive increases. The sub-index on expectations also fell to -9.3 from -2.3 a month earlier, while a reading on current conditions decreased to -20.0 from -14.0.

"What a disappointment," Sentix said in a statement. "After three consecutive increases the sentix index suffered a renewed setback. The decline of 6.5 points causes new question marks." The reading on Germany, Europe's largest economy that has weathered the crisis strongly, fell by 7 points to -1, Sentix said. So, while Germany remains in the economic driving seat, Spain struggles to slash its budget, and Greece continues to grind along the bottom, Howard Davies, a professor at Sciences Po in Paris, writes in today's FT, the French elections - and potential consequences - also remain in the spotlight.

“All the major candidates have made commitments on their Europe policies – to renegotiate this, or abandon that – which may appeal to elements of their target market,” says Davies, “but which will not go down well with the Chablis at the first EU summit after their election.”

On resumption of post-Easter trading, Europe's stock markets opened with the FTSE 100 seeing a fall of 0.9percent to 5,673.44, while the CAC 40 offloaded 1.4percent to 3,273.35, and Frankfurt's DAX 30 fell 1.2percent, to 6,694.55. Spain, Europe's second largest economy saw zero growth last quarter, according to a report by its central bank. Spanish banks could need more capital if the economy continues to deteriorate, Bank of Spain Governor Miguel Angel Fernandez Ordonez said today, adding that a strong recovery of Spain's economy is unlikely in the short-term.

Describing life inside the euro zone firewall as getting even hotter, Pratima Desai, analyst with Thomson Reuters, says how the 700 billion-euro firewall may get tested sooner than expected. “Ten-year Spanish government bond yields are fast approaching 6 percent,” comments Desai. “Insuring 5-year bonds now costs nearly 480 bps, up from around 350 bps in early March. Spanish banks may need more capital if the economy keeps weakening, the Spanish central bank said. The government is struggling to cut its budget deficit to 5.3 percent of GDP this year. Spain is likely to need help. And Italian bond yields have surged, too.”

Spanish banks, already hurting from a property crash, are facing a new wave of loan defaults as the economy sinks into its second recession in three years. Many analysts think it is inevitable the government will have to find more money or ask Europe for help in filling the funding gap. Richard Driver, Caxton FX, tells us how last week saw “heightened concerns surrounding Spain and the onset of a euro zone recession, while UK growth data impressed. Sterling certainly looks well-supported against the euro,” says Driver, “though is still searching for the catalyst for a significant break north of €1.2150 (19-month highs). There are no scheduled announcements this week which look capable to drive this pair much higher, though amid sensitivity to euro zone political headlines, this cannot be written off.”

So, what’s the problem with Europe’s banks? In providing an answer, Kathleen Brooks, (pictured) Research Director UK EMEA, FOREX.com highlights how the banking sector of the Eurostoxx index has given back nearly 50% of the up-move from November to the mid-March high.

“This is important since it suggests that the pullback of the last month is more than just some profit taking and instead highlights real concern on the part of investors about the health of Europe’s banks,” explains Brooks. “Spain’s banks are of particular concern and today the governor of the Bank of Spain said that if economic growth continues to fall then banks may require more capital. This follows alarming newspaper reports about the lengths some Iberian banks are going to get rid of bad real estate loans on their books. This is reminiscent of 2007-2009 in the US banking sector as it tried to deal with the crippling amount of bad real estate loans on its books. The US banking sector has come out the other side but some institutions are mere shadows of their former selves.”

Brooks is correct, especially in pointing out the problem for Europe is that banks and sovereigns share a symbiotic relationship, “so when the banks are weak so are the sovereigns and vice versa,” she says, adding: “After the ECB’s LTRO loans we know that Spanish banks upped their purchases of sovereign debt by about 30percent. However, as we have said before, banks are in a precarious position in Europe and many may have parked their money in sovereign debt with plans to remove it later this year or next to help fund themselves.”

Thus, LTRO-funded purchases of sovereign debt are not a reliable or stable source of demand for the debt of Europe’s weakest nations. With the growth outlook looking particularly weak, especially for Spain, it is hard to see the broader market work up an appetite for this debt, which leaves an important question unanswered: who will buy the tidal wave of European government debt coming to market this year and next? While growth continues to disappoint and concerns about the banks increase, the odds are increasing that Spain may require a bailout at some stage this year. 

Meanwhile, forex news sees the euro continuing to trade in its short term range between 1.3040 and 1.3150. However, the failure to break above 1.3150 suggests to us that the bears have the upper hand, suggesting a move to test the key psychological support level of 1.30 is now on the cards. The only thing that could stop a breach of this level in our opinion would be intervention by a central bank. All eyes are now on central banks to see whether they react to 1, the weak US payrolls data and 2, the heightened sovereign concerns in the currency bloc. Over the last 4 years central banks have always pumped more money into the financial system when the markets have got rough. Which Kathleen Brooks and others believe they will do so again. “However,” she says, “right now the situation is not bad enough to prompt them to take action. We believe we would need to see Spanish bond yields rise by another 100 basis points towards 7percent before the EU authorities and the ECB are forced to take action.”

Drew Hillier. Editor