Newswires are reporting that a big German institution failed the bank stress tests. The fact that this institution had already been taken over by the German government tells us that it was not exactly in great shape.

Indeed, we have to expect some failures in the stress tests, otherwise the markets will simply view the tests as a sham. German Landesbanken are also thought to be vulnerable to failure.

What's also important for markets is not only which banks fail the stress tests, but also what assumptions are made. If the stress assumptions are seen as too lax, that too would be taken negatively by markets.

Official bank stress test results are scheduled for release this Friday starting at 6 p.m. Brussels time (12 noon EST/1600 GMT), and poses the biggest event risk this week for the markets.

Coming out on a summer Friday afternoon adds to that risk, but expect more leaks ahead of Friday. The euro is slightly softer after the headline, though it was already falling back after being unable once again to break the 1.30 area. We note that 1.3094 was the post-European Financial Stabilization Facility high on May 10, and is the next big level up ahead that the euro must surmount.

Markets for the most part are taking negative European developments (Ireland, Hungary) in stride today. Irish 10-year bond yields are up only 6 basis points on the day. With Germany 10-year yields up 5 basis points today, Ireland's spread only widened by 1 basis point.

Greece's bond market is the underperformer today, while Spain and Italy bonds are up on the day. Indeed, Spain bonds outperformed this past week (10-year yield down 26 basis points) even as most of the other peripheral countries underperformed Germany.

Part of Spain's story was its ability to place 3 billion euro in new 15-year bonds last week, albeit at significantly higher yields than the last auctions in April.

The ECB signaled today that it bought only 300 million euros in peripheral bonds last week, the lowest since the program started in May.

Since private demand was fairly strong last week (Portugal also placed debt easily), the need for the ECB was clearly lessened. Still, we note that bond spreads, while narrower than they were in May and June, are still pricing in serious default risk. European outlook remains quite cloudy, and that may ultimately keep a lid on this current euro correction.
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