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Wednesday Look Ahead: Watch the Financials, Euro

The financial sector will be at the crux of market worries Wednesday, as the U.S. Senate moves closer to a vote on banking reform and German regulators explain their surprise move to ban naked short-selling on a group of bank stocks and sovereign debt.

Investors are looking for clarity on Germany's late day move Tuesday to ban naked short selling in the shares of 10 German financial institutions and in euro zone sovereign debt. The ban, which took effect at midnight, would also apply to credit default swaps based on those bonds. German officials hold a press briefing on the ban Wednesday.

As news of the rules slipped out during the early afternoon in New York, the euro went into a dive, taking risk assets, like stocks and oil with it. The euro fell to a fresh four-year low against the dollar, touching $1.2161 before finishing at $1.2213. Oil fell nearly 1 percent to $69.41, its lowest close since last September.

The Dow finished down 114 points at 10,510, after being up as much as 93 points on the day. The S&P 500 fell 15 points, or 1.4 percent, to 1120.

Euro Trashed

"The measures today were missing the forest for the trees," said David Gilmore of Foreign Exchange Analytics. "Really all they do is channel more of the market risk takers into expressing their negative view on the euro zone into the currency."

Euro
Euro

"It says a lot of why the euro went to a new four-year low today, and that was after spending most of the day strengthening and squeezing out short positions. In any crisis, there's always going to be policy mistakes. Some of the mistakes are going to be bigger than others. This has the potential to be quite big. It may not be a Lehman mistake, but it's right up there," he said.

However, Stephen Stanley, chief economist with Pierpont Securities, said he doesn't believe the moves will make that much of a difference unless other countries join Germany.

"From what I read, it looks like it's really mostly symbolic. They clearly have the ability and authority to prevent short selling on those German stocks, but I don't think this has much teeth when it comes to euro bonds and CDS... Much more of those trade in London than in Germany," he said.

The European Debt Crisis - See Complete Coverage
The European Debt Crisis - See Complete Coverage

Goldman Sachs' European economists, meanwhile, said they believe the move was made by German officials to make the expected passage of the $440 billion euro bailout package Friday more palatable to the German parliament. They also say they expect other countries to follow Germany's lead.

The new rules are valid until next March 31, and it appears to have some exemptions for market makers who need to hedge.

The news leaked out after European markets were closed, but it rattled U.S. investors who remembered U.S. regulators banning short selling in financial stocks during the thick of the financial crisis.

"What bothers people here, in as much as it smacks of desperation, is when we got to the stage where we were eliminating short selling, we were in deep, deep trouble. I wouldn't have thought the situation was so dire over there to take those actions. It's pretty clear policy makers are out of control, and they're flailing around. That's not going to make the euro stop going down," said Barry Knapp, head of U.S. equities strategy at Barclays Capital.

Fin Reg

Congressional efforts to enact financial regulatory reform legislation has been a long process, and now that the Senate moves toward a potential vote later this week, the market is taking more notice. The S&P financial sector was down nearly 2.8 percent Tuesday, giving it a 7.8 percent decline this month.

"I don't think people had really done the analysis on this, and all of the sudden, we're at the verge of it, and now people are putting pen to paper and they're saying 'wow,' he said. Knapp said if rules similar to Basile III capital standards were applied to U.S. banks, the top 20 banks would need an additional $160 billion in capital.

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The Shape of Financial Regulation



Even after the Senate approves a bill, the final shape of legislation will still be unclear. The Senate bill will have to be reconciled with a bill passed previously by the House of Representatives.

"It all adds up to the same thing, which is a pretty big hit to the forward earnings outlook. It is also unclear for what it means for credit creation and the economy," he said.

"The problem with fin reg here is if you get a vote on, let's say Thursday night, you've got headline risk the day before an (options) expiration. Just from a market perspective, that's added a level of complexity. That's just not what traders want to deal with," Knapp said.

Goldman Sachs analysts Monday issued a report saying the proposals so far in the regulatory reform bill present about 20 percent risk to normalized earnings per share for banks. They also said the moves in CDS and options markets imply the stocks of financials may be about 6 percent too expensive.

Widely followed bank analyst Meredith Whitney also Monday said that she would avoid the group, as regulatory reform will dent their earnings and restrict lending.

On Tuesday, Sen. Christopher Dodd, D-Conn. made moves to compromise on a key and controversial feature of the Senate bill which would force banks to spin off their swaps desk. Dodd suggested a proposal to delay any ban on bank derivatives operations for two years while federal regulators study the potential impact. But Sen. Blanche Lincoln, D-Ark., who proposed the rule said she would fight any effort to weaken it.

What Else to Watch

Consumer price index inflation data is released at 8:30 a.m., and minutes of the Fed's last meeting will be released at 2 p.m.

Stanley said the market more likely than not will brush off the Fed minutes. "The meeting was before the European stuff came to a head...It's pretty clear to me that the Fed reaction in all of this has been pretty cautious and aggressive, opening up swap lines again and the rhetoric..It takes teeth out of any hawkish noise coming out of those minutes. People will dismiss it as old news. If it's dovish, people could say, 'geez, if they were dovish before all this happened, where are they now?'" he said.

Stanley said he had been expecting the Fed to move toward a tighter monetary policy by September, but now thinks the Fed will wait until next year because of the European situation.

Hewlett-Packard, meanwhile, may get some focus after it reported better-than-expected earnings and raised its full year outlook after Tuesday's bell. The company earned $2.2 billion on revenues of $30.8 billion.

Earnings Wednesday include Target ,Limited Brands , and Polo Ralph Lauren .

Knapp pointed to the decline in consumer discretionary stocks Tuesday, even after some good retail earnings.

"This is the stage in the economic cycle where you would expect consumer discretionary would have been a big winner, and it's not trading particularly well... Some of it's cyclical rotation..but I'm not so sure I want to say it's a bad sign about the economy. It does tell you there were a lot of people in the trade.

You put all these things together -- You have fin reg. You have the euro going down and you have retailers not responding to good earnings and that's making for a pretty good drubbing I suppose," said Knapp.

Who Dunnit?

The SEC and CFTC still don't know what caused the market plunge May 6, but they will continue to study it and they have six scenarios they are pursuing. Those include a mismatch in liquidity, disparate trading rules, and linkages between the decline in stock index products such as index ETFs and the e-mini S&P 500 futures.

They did say they found no evidence of a fat finger trade, computer hacking or terrorist activity but they could not completely rule out those possibilities either.

The SEC issued new rules on single stock circuit breakers, where it would require a five minute trading halt if the price declines by 10 percent in a five minute period.

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