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The recapitalization of the banks may prove to the be easiest part of the banking sector problems. Many countries are over-banked, and bank profitability is poor. Bank analysts argue that there are too many branches (the OECD estimated that Italy has more bank branches than pizzerias), which are a source of local employment. The unorthodox monetary policy and negative interest rates have undermined the net interest margin, while the weak growth has undermined the demand for credit.

Also on July 19, the ECB's lending survey will be reported. It will likely acknowledge that a tightening of lending conditions took place in Q2. Two days later, the ECB meets. The post-Brexit decline in yields exacerbates the shortage of German bunds that qualify for the ECB's purchase program. This has increased speculation that the ECB will abandon the capital key (determined by the GDP and population), which favors the large countries, and especially Germany. The alternative that captured many imaginations is a debt market key, which would favor the large debtors, especially Italy.

We suspect the market is getting ahead of itself. First, the capital key is very important principle that the ECB will be reluctant to abandon without exhausting milder measures. Second, less aggressive measures do exist, such as removing self-imposed limitations such as the deposit floor on purchases or the country cap. Third, some investors and commentators may have a greater sense of urgency than officials. After the initial drop in response to the Brexit decision, yields have backed up in recent days.

If we are correct in our assessment, many participants may be disappointed with the ECB on July 21. The economy and prices are evolving pretty much as the ECB expected. The flash PMI for July is released the day after the ECB meeting, and the composite is anticipated to slip lower, but should still be consistent with around 0.4% Q2 GDP. The capital markets have stabilized and by many metrics, not far from where they were on the eve of the referendum.

Just before the weekend, it appeared Turkey was offering a new drama. However, the coup attempt was defeated, and the immediate market impact looks minimal, or at least likely to be localized to Turkish markets. The more significant fallout will likely political in nature. President Erdogan, whose authoritarian-style and move away from a secular state already was already the source of criticism is likely to go even further down this path.

There is speculation that Erdogan may have spurred the coup in a "false flag" operation, we are skeptical. However, we recognize Erdogan as a savvy political actor and anticipate his ability to turn the failed coup attempt into his advantage.

Erdogan claims that his once ally, Gulen, who left Turkey in 1999 and now resides in the US, was the mastermind of the coup, and demands his extradition. The US (and Europe) quickly supported the democratic government in Turkey in the face of the coup, but has requested evidence of Gulen's guilt before sending him to home. One need not be cynical to be skeptical of his chances of a fair trial.

Turkey's military is the self-appointed defender of secularism and has intervened at least four other times since 1960. The popular narrative and one that Erdogan is promoting of course is that the coup failed because the people, encouraged by the President himself on social media, took to the streets. That may be part of the story, but the military itself appeared divided and this added to the drama. On balance, turning the coup back means the status quo prevails in terms of macroeconomic policy within a probably more autocratic context.

Marc Chandler‚Äč
Global head of currency strategy at BBH
Brown Brothers Harriman

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