November 27th 2011: Weekly preview - A point of no return?
Initially, markets will be watching closely to see whether Spain and Italy look to tap the new IMF lending facility. Such a move would be likely to boost market confidence temporarily and push the Euro higher again, but it will be extremely difficult to find durable relief. Indeed, this could prove to be the week of no return for the current Euro structure, especially if markets don't buy into an IMF rescue. The Euro-zone plummet towards a break-up is continuing to accelerate and without a new course of action extremely quickly it will certainly be too late to pull out of dive, especially with necrosis threatening to spread to Germany.
The vice-like grip of market pressures will continue to build, especially with stresses set to intensify as capital outflows become a torrent. Further delay will continue to increase the scale of any policy response required to provide a solution while it also raises the internal political barriers to any form of action. European leaders must find a solution which allows a turn in market sentiment and provides long-term hope even if the short-term cost to the banking sector is high. There is still a strong probability that the Euro area will have to be split into two and this needs to be enacted extremely quickly given a growing threat to social cohesion.
Principal attention will again focus on German Chancellor Merkel and the ECB. Markets have been expecting a U-turn from Merkel, but she has so far refused to budge on her opposition to Eurobonds. The message is clear that the bonds could only be issued at some point in the future when economic and fiscal integration, together with the control of individual countries, was strong enough to prevent the kind of divergent policies which led to the current wreckage. While this may be a viable long-term strategy, markets are working to a completely different timescale. It is also clear that half-baked solutions are having a shorter and shorter impact and there is no chance that Treaty changes can be agreed in time.
Bond auctions and yield trends will inevitably be watched very closely with another round of important Italian auctions due and there will also be an important French offering. Any further upward pressure on yields would intensify the crisis. There will be Euro-group meetings on Tuesday followed by ECOFIN talks on Wednesday.
The banking sector will be an extremely important focus during the week. Distress levels in the markets have been steadily increasing with the benchmark 3-month dollar Libor rate rising for 104 consecutive days to near 0.52%. Other stress indicators are also at the highest level since 2008. Although they are as yet nowhere near the panic levels seen then, the damage will be very real, especially as banks are already in an extremely vulnerable position.
The European banks in particular will be extremely important, especially following reports that Dexia was having to tap emergency central-bank funds to keep afloat last week. Bank and government officials face an almost impossible task in shoring-up confidence. From the standpoint of funds, corporates and individual investors, there is no downside risk to moving out of weaker banks and countries. Similarly, there is no upside to leaving deposits invested and the rational choice is clear.
Most of the economic data will struggle to have much impact, although there are certainly important releases on tap. Principal attention will inevitably focus on the latest US employment report with markets expecting another subdued increase in jobs for the month.
There will be an important impact on risk appetite and hopes that the US can provide global leadership will increase slightly if there is a stronger than expected figure on Friday. Europe is in no position to offer leadership to the global economy while there are increasing fears surrounding China and the Asian economy as a whole. This will increase pressure on the US to keep the global economy afloat. Any suggestion that the US economy is stalling would trigger another spasm of risk aversion and fear.
The data will also have important implications for Fed policy as Bernanke and his coterie of doves will have a much stronger reason to press the panic button and further quantitative easing if there is evidence of fresh deterioration in the economy. In this context, there could be a quick reversal of risk aversion on hopes that the Fed will again ride to the rescue. In this context, it will be extremely important to look for a cathartic selling climax.
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