For the better part of this year, the exacerbation and settling of concerns surrounding balance sheet problems in Europe has commanded the volatility in the financial markets. This Friday, it is believed the EU bank stress test results will give euro bulls the green light to take the currency above 1.30 and perhaps as high as 1.35. In fact, risk appetite in general hinges upon the outcome of the stress tests.

What is the Goal?

It is no secret that the goal of the stress tests is to restore confidence in the banking sector by proving that the financial situation within banks is not nearly as weak as many people fear. A total of 91 banks will publish their stress test results at 12:00pm NY time or 16:00 GMT on Friday. These banks represent 65 percent of the EU’s banking sector and at least 50 percent of the national banking sectors in each country. The Committee of European Banking Supervisors (CEBS) is expected to publish a statement summing up the results a minute later.

Top 5 Outstanding Questions

These are the top 5 questions that the market needs answered on Friday for the EUR/USD to sustain its gains.

1. What is the capital threshold used to determine Pass versus Fail?
2. Will more details such as the criteria and methodologies be provided other than a Pass/Fail mark?
3. What haircut will be used to mark down government debt?
4. Will the decline in bond prices be written off as temporary for permanent?
5. If banks fall short of capital requirements, how long will they have to raise funds?

The European Union and the CEBS have not provided details on what threshold will be used to determine whether a bank has passed the stress test and if the results will contain more detail than a simple pass/fail label. Six percent has been circulated as the passing threshold for core tier 1 capital, but that has not been confirmed or denied by regulators. If a bank falls short of the threshold, it is also unclear how long they have to raise the funds and where it will come from. Another outstanding question is the haircut for sovereign risk, which is the amount that the bonds would be written down to account for default risk. Once again, unconfirmed numbers have also been floated around for haircuts with the media reporting a loss assumption of 17 percent on Greek debt and 3 percent on Spanish bonds. If these are the percentages that they go with they are too modest and will not provide much confidence to investors because of the risk of default is seen to be much greater. Some people are calling for regulators to apply a haircut of 50 percent on Greek debt but they would never do so because the point of the tests is to restore confidence and not to exacerbate aversion. Whether the decline in bond prices is judged as temporary or permanent will determine how the assets will be treated and if they are marked to market or held to maturity. There have been a lack of common procedures amongst the regulators in the region and if the details of how the banks were tested are not revealed, it could create more confusion than transparency.

Will the Stress Tests Really Help the Euro?

For currency traders, the most important question is how the results will impact the EUR/USD. The hope is that it will provide the same support to European Financial markets as the U.S. tests did for the U.S. Yet it is important to realize that the results of the U.S. bank stress tests did not help the U.S. dollar. In fact, the greenback has sold off aggressively against both the euro and Japanese Yen since May 7th, 2009. Of course, the weakness of the dollar was a reflection of safe haven flows easing and not concerns about the U.S. banking sector exacerbating. In fact, the performance of U.S. stocks confirms that the stress tests were a big success. Therefore as long as the results provide sufficient answers to the top 5 questions outlined above, the EUR/USD should receive a nice boost following the announcement. However if any of the 5 questions are insufficiently addressed and we think this is a significant risk, there could be a classic buy the rumor sell the news move in the EUR/USD that causes it to give up recent gains.

Kathy Lien is Director of Currency Research at GFT, and runs KathyLien.com.