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The short interest in Canadian bank stocks remains at record levels.

Michelle Siu/The Globe and Mail

The S&P/TSX composite is well-positioned to weather the European storm with gold prices rising quickly and oil prices stable, despite a strengthening U.S. dollar.

If there's going to be a problem for Canadian investors, it will be bank stocks, and we have the Italians to thank for that.

Domestic banks generate very little of their profits from U.K. or European operations, so it makes little sense that their stocks should drop because of financial upheaval in those markets. But equity markets, possibly because of 2008-related post-traumatic stress issues, view all developed-world banks as interconnected and to a significant degree, they all trade in the same direction (although admittedly not in the same proportions).

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The European debt crisis in 2012 taught Canadian investors a painful lesson about the global sensitivity of domestic bank stocks. From the end of March to the beginning of June, 2012, the S&P TSX bank index dropped more than 10 per cent because of the intensifying financial stress in Europe. It doesn't look disastrous on the long-term chart, but Canadians were extremely concerned at the time, unused to such rapid, sharp downward moves in a domestic sector considered among the most safe.

The U.K. referendum has renewed focus on the wretched state of Italian banks, where weak economic growth has left the sector with €85-billion ($122-billion) in non-performing loans. The Financial Times reported that the Italian government is appealing to EU officials to provide emergency financial support (which is against EU regulations) and bank share purchases by public entities.

The chart below shows why this matters to Canadian investors. It compares the performance of the S&P/TSX bank index with the cost of credit default swaps (CDS) on five-year debt issued by Italy's largest bank, Banca Intesa Sanpaolo. The cost of CDS rises as fears increase – debt insurance is more expensive when financial trouble strikes – so the grey line is plotted inversely to better see the trend. The current cost of Intesa Sanpaulo CDS on five-year debt is 177 basis points, which means default protection cost nearly 1.8 per cent of the face value.

The correlation between Canadian bank stocks and Italian bank debt protection is remarkably high. Domestic bank stocks fall as CDS costs climb. Most recently, Intesa Sanpaolo CDS has jumped by 54 per cent and the Canadian bank index has dropped 3 per cent.

By no means am I suggesting that there is a direct connection between the financial health and profitability of domestic and Italian banks, just the stock prices. That's the good news – financial stress in Italy and across Europe should have very little or no effect on Canadian bank profits. Any selloff in domestic banks will almost certainly be sentiment-driven, not a reflection of endangered profits.

Investors can expect domestic bank stocks to be volatile, and perhaps weaker than local business conditions suggest they should be, until more clarity is apparent in the future of Britain and the rest of the European Union.

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