This Week, It’s Deal or Die for Euro

12/05/2011 11:00 am EST

Focus: FOREX

Brian Dolan

Chief Currency Strategist, FOREX.com

This week will likely see either an agreement to bind Eurozone nations’ fiscal policies together with irrevocable, enforceable institutions or the beginning of the end for the single currency.

We have been here before, and so far, EU leaders have never failed to disappoint, but they must surely recognize by now that markets have run out of patience and a global financial crisis awaits if they don’t make concrete commitments to credible fiscal governance.

I am actually optimistic for the first time in this never-ending saga since European Central Bank (ECB) President Draghi on Thursday indicated the ECB would deploy its virtually limitless balance sheet to support Eurozone debt markets, but only if there is a new “fiscal compact” between Eurozone nations.

The alternative to no agreement would be a collapse of European debt markets, which would trigger Eurozone financial sector failures and quickly cascade into a global financial meltdown, making Lehman Bros. seem like a mom-and-pop candy store going out of business. Even emergency intervention by the ECB after that cascade began would likely be unable to stem the cataclysm.

The action will begin as soon as today, as German and French leaders are set to hold a critical meeting where they will need to hammer out an approach they can take to the full EU summit on Thursday and Friday. Further French foot-dragging at this meeting would be a death knell for the process, and despite Sarkozy’s reluctance, he will need to acquiesce and cede sovereignty over budgets to a centralized EU authority or set of rules.

Also on Monday, Italian Prime Minister Monti will submit his economic plan to parliament. The urgency of the week is highlighted by US Treasury Secretary Geithner’s meeting with German, French, and Italian counterparts next week, where I suspect he will drive home the message that decisive action has to be taken or the risk is catastrophe.

I don’t expect treaties or agreements to be signed this week, but at the minimum, markets will be expecting detailed provisions (budget deficit limits, debt limits, surveillance and enforcement mechanisms, and the like) to be spelled out and agreed to at the EU summit on Friday.

If they are successful, the ECB now seems prepared to provide interim support to EU debt markets, likely forestalling an immediate confidence and liquidity crisis. Even if they do reach an agreement on concrete terms of tighter fiscal integration, markets may still not be persuaded and stresses could yet break out. If they fudge it again, get the helmets out!

NEXT: 5 Major Central Bank Decisions Due This Week

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Outlook for New Central Bank Decisions

Five major central banks are making rate decisions this week. The Reserve Bank of Australia (RBA) is up first with a decision due out on Tuesday afternoon local time down under. Market consensus is nearly evenly split between those looking for a steady 4.50% rate and a 25-basis-point (bp) cut to 4.25%.

Consumer inflation expectations have recently moderated to fall back within the RBA’s desired range at 2.5%, and given global market tensions, I would not be surprised to see the RBA cut. However, it’s a close call as growth remains resilient. I would look for AUD to trade more in line with overall risk sentiment this week based on the Eurozone developments outlined above.

The Bank of Canada (BOC) is expected to hold rates steady on Tuesday morning and BOC policy should stay on hold for the foreseeable future.

The Reserve Bank of New Zealand (RBNZ) announces on Wednesday evening ET/Thursday morning Wellington time, and is also expected to hold steady, with recent strong growth being offset by global tensions, postponing a rate hike into 2012.

The Bank of England (BOE) is up first on Thursday morning ET, and the benchmark rate is expected to stay on hold at 0.50%, but the risk is that the monetary policy committee (MPC) doves respond to the deteriorating outlook and increase the amount of QE, last at GBP275 billion.

The ECB decision on Thursday morning ET will be the highlight of central bank meetings for the week. The ECB is widely expected to cut rates by at least 25 bps to 1.00%, with many calling for an emergency-type 50 bp cut to 0.75%.

I think the ECB will proceed more calmly and cut only to 1.00%. The ECB is also expected to undertake a number of additional measures to support banks’ liquidity. In particular, I am looking for the introduction of additional long-term repo operations (LTRO’s) for two- and possibly three-year terms, and an easing of collateral conditions for ECB lending.

The ECB is also likely to acknowledge the further deterioration in the economic outlook and perhaps even suggest that deflation is now on the horizon. I would expect the ECB decisions to weigh on EUR overall, but again, EU summit and debt market developments will likely be more significant for the single currency.

Overall, though, I would expect to see EUR decouple from recent high correlations to risk assets like stocks, but in asymmetric fashion (risk off, EUR weaker/risk on, EUR not necessarily stronger).

See related: “Risk-on” and “Risk-off” Trades

US Political Wrangling Clouds Outlook

On Friday, a group of US Republican lawmakers indicated they were pursuing legislation for the US to block the International Monetary Fund (IMF) from bailing out embattled Eurozone governments like Italy or Spain.

News of the initiative added to the EUR’s decline following the anemic US employment report, but the move has no chance of succeeding and would be vetoed by the White House in any event. Even the Republican leadership announced that they would not support the measure, likely consigning it to mere political posturing.

More importantly, the payroll (Social Security) tax cut expiring at the end of the year has yet to be extended, with the two sides disagreeing over how to pay for it. If the tax cut were to lapse, it would shave about 0.8% from 2012 US GDP, making it a potential serious threat to the US recovery.

But 2012 is an election year, and to allow tax rates to rise for the entire working population would be political suicide for the offending party, so at a minimum, I would expect the tax cut to be extended, but not paid for.

Extended unemployment benefits are also set to expire at year-end and need to be renewed or millions of long-term unemployed will begin to lose benefits, also dampening the near-term outlook. This is a closer call, but I think it will also be passed, effectively maintaining the status quo into 2012.

By Brian Dolan, chief currency strategist, FOREX.com

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