The Forex Trading Week Ahead

12/12/2011 10:16 am EST

Focus: FOREX

Brian Dolan

Chief Currency Strategist, FOREX.com

Last week’s European summit produced disappointing results, and though significant risk factors remain, stocks and major currency pairs stayed surprisingly stable, pending this week’s news and further developments.

The much-anticipated EU summit delivered on the basics of establishing new fiscal rules to prevent a future debt crisis, but has failed to resolve the near-term debt crisis, namely how troubled European governments will maintain their debt service if credit markets turn on them again.

The EU agreed to provide an additional EUR 200 billion to the International Monetary Fund (IMF) in the form of bilateral loans, providing a bit more of a backstop to the under-powered European Financial Stability Facility (EFSF) and European Stability Mechanism (ESM). Proposals to increase the size of the ESM were put off until March.

On Thursday, ECB President Draghi shocked markets by indicating the Bank had no plans to increase its government debt purchases even if the EU fiscal compact was strengthened. Government bonds of Spain and Italy, in particular, sold off sharply in response to Draghi’s reversal, sending yields sharply higher and back into unsustainable territory.

Italian and Spanish yields surged higher again early on Friday as the results of the EU summit emerged and were deemed insufficient to counter a credit-market backlash. Only subsequent ECB buying of those bonds as part of their minimal Securities Market Program (SMP) brought those government bond yields back down. We will be paying close attention to European debt markets this week for signs of further stress.

And it’s not just the government debt crisis that remains at risk of relapse. The European banking sector remains in jeopardy as investors remain reluctant to fund some of the continent’s largest banks. EU banks were found to be in need of EUR 115 billion in new capital following stress tests by the EBA, and three of the largest French banks had their long-term ratings cut one notch by Moody’s.

In short, the EU summit might look good on paper, but it comes up short in convincing investors that funds will be there to prevent a sovereign borrowing collapse. EU leaders provided no new initiatives to promote growth and simply recommitted to austerity programs, which keep the growth trajectory tilted south, increasing the debt burden even further. This week will see the December ZEW and PMI surveys for France, Germany, and the Eurozone, where further declines are likely to reinforce the view that Europe is heading for a recession, if not already in one.

NEXT: Market's Surprising Reaction to EU Summit

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Market Reaction Is Puzzling

Despite the disappointment over the EU summit felt by most market observers, risk markets managed to rebound on Friday. For the week, EUR/USD was essentially unchanged, which was not the result one would expect given the risks still facing the single currency.

Other risk assets (e.g. AUD/USD, EUR/AUD, NZD/USD, S&P 500, and crude oil) finished the week either unchanged or nearly so, suggesting that risk sentiment remains uncertain and still undecided. Italian and Spanish government bonds, however, show clearer indications of a rejection of the past week’s attempts to rally, suggesting prices may fall again and yields may surge higher.

It may be that we’re facing another Wile E. Coyote moment, where markets have gone off the cliff, but haven’t looked down yet. There may also be a growing resignation that the worst-case scenario of a Eurozone breakup will not ultimately come to pass, or that the hodgepodge of lending facilities the EU/IMF has come up with will together be enough to prevent a sovereign debt collapse. Or that they have bought themselves some more time, postponing the day of reckoning once again.
Word on Friday that China has initiated a new $300 billion investment vehicle, with half destined for Europe/half for the US, was the proximate catalyst for the risk rebound on Friday, which may not prove sustainable.

For the EUR in particular, the ECB’s refusal to commit to using its balance sheet on a larger scale (turning on the printing presses) to support EU debt markets is certainly helping to limit the downside.

Whichever flavor one chooses, there is a growing risk of a capitulation in risk-off positioning, meaning a potentially sharp rebound in EUR and risk/selloff in USD, likely exacerbated by lower year-end liquidity and market interest.

See related: What Is a “Risk-on” Trade?

We would highlight the 1.3500/1.3600 area in EUR/USD as a potential trigger to a short squeeze higher. Alternatively, a drop below 1.3150/1.3200 would suggest markets are experiencing more intense risk aversion on deteriorating fundamentals and may see risk assets decline into the end of the year. In the meantime, inertia within recent ranges should continue to prevail.

Plenty of Risks Remain

We already highlighted the December ZEW/PMI gauges as potential stumbling blocks to a further rebound in risk and EUR. Turning back to the EU summit result, we would expect to hear word from S&P and other ratings agencies early this week on the possibility of sovereign downgrades.

The summit result does not look sufficient to prevent at least some ratings cuts, as S&P cited high household/government indebtedness and weak growth outlooks, which the summit pact does nothing to address, as grounds for a lower rating.

Still, it’s a close call, and we would note the increasing numbness with which markets view ratings agencies’ opinions. Italy, Spain, and Portugal will all be auctioning debt of various terms this week, and the results will be critical. Greece has talks with the Troika on Monday to ensure funding is available to cover about EUR 7 billion of debt issues maturing this week.

By Brian Dolan, chief currency strategist, FOREX.com

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