FYI | Dec 08 2011
By Kathleen Brooks, Research Director UK EMEA, FOREX.com
There are two major events in the next two days In Europe: the ECB meeting and the EU summit. Since central bankers and politicians have the power to resolve the sovereign debt crisis this week’s events are a potent mix for financial markets. So what do we expect?
The EU Summit:
This kicks off tomorrow in Brussels, and starts with a session for all 27 EU leaders at 1830 GMT. There is another meeting scheduled for 0930 on the 9th December and usually there is a press conference at the conclusion of the summit – this didn’t take place until the early hours of the 27th after the October 26th summit, so it could be a late night in Brussels and the market reaction may not be felt until the Asian open on Sunday night.
So what do we know so far and what is the market expecting? Firstly, the markets expect hard measures towards closer fiscal union, secondly extra bailout funds and lastly a greater role is expected for the ECB so that it can buy sovereign debt on a much larger scale.
This is a huge amount to expect from one summit and already an unnamed German official has tried to dampen expectations saying that he was more pessimistic about reaching a complete solution this week compared to last week, and hinting that there was some discord between the member states over how to reach fiscal union. Added to this, German Chancellor Merkel has ruled out Eurobonds once again, so fiscal union might not be as forthcoming as some would like.
So we might not get the all-singing, all-dancing solution we want on Friday then what should we expect? There is likely to be progress made on tighter budgetary rules and possibly fines against members that break these rules. But this is not likely to be enough since there have always been fiscal rules in the Eurozone, so this may not placate the markets since most members, including Germany, have flaunted these rules over the past decade.
We also need to get clarity on private sector involvement regarding bailouts and whether bondholders will be forced to accept bailouts going forward. Merkel suggested on Monday that she was scrapping that proposal, but we need to find out whether that means no haircuts period or just no haircuts for original holders of Eurozone sovereign debt.
The other area we expect to hear more about is whether these changes would require a Treaty change. With EU members like Britain threatening to use a Treaty change to bring powers back from Europe and onto domestic shores, we expect the Eurozone leaders to try and resist this option and already EU President Von Rompuy has said that changes to fiscal rules may not require Treaty changes, but this could come up against some opposition especially from the anti- European factions within European governments.
There should also be greater clarification around the ESM – will it be brought forward to mid-2012 as Sarkozy mentioned on Monday… We also want to know what the IMF’s role will be. Will the ECB lend to the IMF to help member states in financial trouble or will it be used as a monitor to ensure all members adhere to fiscal rules?
As we get closer to the main event it seems like our expectations are too high and we could see risk struggle to gain traction before Friday. Fiscal rules and debt ceilings are all well and good, but they don’t really deal with the problem at hand: European nations struggling with huge debt loads and aging populations, like Italy. It also doesn’t address the key problem of massive imbalance in the currency bloc – surplus nations need to help out debtor, less competitive nations, otherwise a debt crisis remains on the cards.
The ECB meeting: Keeping ammunition in the back pocket?
We agree with consensus and think that the ECB will cut rates by 25 basis points tomorrow, reversing all of this year’s prior rate hikes. However, there is a chance that the ECB cuts by 50 basis points as the ECB staff projections are also released at this meeting and we expect a large downward revision to 2012 and 2013 inflation and GDP estimates. We expect the ECB to have similar estimates to the European Commission, which predicted a dismal rate of growth for next year for the currency bloc of just 0.5% along with falling inflation. Combined with a rising chance of a mild recession next year, new ECB President Draghi may think that there are enough problems out there for a 50bp cut.
Mario Draghi is likely to strike a dovish note during his press conference after the rate announcement. If the Bank cuts by 25bp then he is likely to suggest further cuts are waiting in the wings. Although if he does this he opens himself up to criticism of why doesn’t he act now, so we expect him to tread carefully during his speech and the Q&A afterwards.
We also expect the ECB to announce extra measures to provide euro-based liquidity to the banking sector.
We think that the effect of a rate cut on the euro could be limited since it works in opposing ways: a rate cut could boost growth in the currency bloc, but it would erode the Eurozone’s rate differential, which could leave the single currency range bound. We think that the outcome of the EU summit is more pivotal for EURUSD since a good outcome could see the dollar come under pressure as safe havens get sold off, and vice-versa.
Extra liquidity combined and the scrapping of haircuts for private sector bond holders could boost bank stocks in Europe. Because banks are leading the overall European stock index we could see more upside in European stocks than in FX in the next couple of days depending on the outcome of the summit.
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