While the outcome of this week’s EU summit is the key event that will drive the markets, controversial actions from the Fed and a possible move by the Bank of England are noteworthy as well, explains Kathleen Brooks of FOREX.com.

Fed policy is always eagerly awaited by the markets. In recent years, markets and investors have become accustomed to the Fed stepping in to calm markets when the going gets tough. However, there were no bones from the Fed for the market to feast on last week. Ben Bernanke and company decided to extend the Operation Twist program until the end of the year rather than embark on more quantitative easing (QE).

The extension of the Twist program means that the Fed will continue to buy longer-dated Treasury securities (six to 30 years maturity) in a bid to push down long-term rates make credit easier and cheaper for consumers and businesses to get their hands on. It will fund these purchases by selling shorter dated securities, thus putting upward pressure on short-term rates. This extension shouldn’t impact the size of the Fed’s balance sheet, and thus should only have a marginal impact on the dollar.

This move has proved to be fairly controversial. The Fed has less than $300 billion in short-term securities left to sell on its balance sheet, which is a fairly paltry sum and may not have much of an impact on longer-term interest rates due to the huge size of the Treasury market.

Some argue that the Fed hasn’t done enough to protect the economy from either 1) a Eurozone sovereign debt shock; or 2) further weakening in US economic data. The market reaction was to sell stocks and buy the dollar, and the dollar subsequently jumped 100 basis points on a broad-based scale.

However, the impact on Treasury yields was fairly muted. After rising above 0.3%, the highest level since May, the two-year Treasury yield fell back again as concerns about global growth caused safe-haven flows into the US debt market.

See also: Safe Havens that Replace Gold and Bonds

USD/JPY was a big mover, as the market priced in the prospects of the Bank of Japan doing more stimulus compared to the Fed. This cross jumped above 80.00, although 80.50 was thwarting the bulls by Friday afternoon.

The spread between ten-year US and ten-year Japanese bond yields usually follows USD/JPY closely, however, after initially widening, this spread had fallen back at the end of last week. Although the Fed may not give in to the market’s wails for more liquidity right now, it left the QE card on the table to use on an even rainier day. While the Eurozone sovereign debt crisis continues to rage on, Treasuries will remain in demand, which could act as a cap on dollar gains.

We will be looking for a weekly close above 80.10 (the base of the daily Ichimoku cloud) in USD/JPY to get constructive on this pair. Added to that, a successful outcome of the EU summit this week could give the green light to dollar bulls to push this pair even higher.

NEXT: Worrying Signs for Global Economic Growth

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Worrying Signs for Global Growth

Although the Fed didn’t help the markets by giving them more QE, it was the sharp decline in global growth indicators that caused stocks, especially in the US, to really sell off last Thursday. The Nasdaq 100 (a key indicator of global growth expectations) fell below its 50- and 100-day moving averages, which fuelled further losses for this index.

Likewise, the transportation sub-index of the Dow Jones also rejected a move above the top of its range at 5,350, which fueled some selling, although the 50-day moving average helped to cushion the blow by acting as support. This suggests that investors are nervous and the rally in US stock markets could be halted for now.

Markets had to digest the prospect of the world’s biggest economies all slowing at once. China, Germany, and the US all registered weak manufacturing growth in recent weeks. Since this data has a strong positive correlation with GDP, it suggests that Q2 could see a slowing in global growth that may dent business and economic confidence. This is what is weighing on stocks and fueling inflows into safe havens like Treasuries and German Bunds.

The Eurozone debt crisis is one of the reasons why business and economic confidence has fallen in recent months, thus, a swift solution to the sovereign debt crisis at this week’s EU Summit could help growth to recover. Rather than wait for action from the Fed or the PBOC in China, action by the ECB to stem the crisis could be more effective at boosting global growth in the long term. Also, the decline in the oil price could ease pressures on global economies. Thus, there seems to be a silver lining to the dark cloud hovering over the global economy.

Thus, as we wait for the outcome of this week’s EU summit, we may see stocks start to consolidate. The S&P 500 may trade between 1,360 and 1,300 in the coming days. Until we get a clear picture on the outlook for Europe and the fate of the currency bloc, then it’s hard to pick a direction for stocks and other risky assets (see below for our preview on the EU Summit).

Spain Asks for a Bailout

In the lead up to the EU summit this week, there have been a couple of important developments. First, Greece’s pro-bailout New Democracy Party formed a government after the elections on June 17. This secures Greece’s place in the Eurozone…for now. Although Greece still faces enormous challenges, the tail risk of it leaving the currency bloc in a disorderly way has been greatly reduced (again, for now.)

Also, we have more clarity on the extent of bad debts on Spanish bank balance sheets after the preliminary results of an independent audit on its banking sector were released last week. Although there were concerns that the auditors only got to see data collected by the Bank of Spain, the EUR 60-70 billion in bad debts owned by the banks was large enough to inspire confidence in the markets that the tests were stressed enough, while the losses were not large enough to be unmanageable.

Spain has a EUR100 billion line of credit with the EU/ECB and the IMF that the nation is expected to tap into on Monday when the finance minister is expected to send a letter to the EU to formally request funds.

On Friday, we got the details of what the bailout would look like. The bailout loans could come from the EFSF/ESM bailout funds, and the finance minister said there are ongoing discussions about imposing losses on junior bond holders. The markets were remarkably sanguine about this, as it suggests private sector bond holders could get burned. This is problematic for Madrid; will the very banks it is trying to bail out, who at the same time have been buying up Spanish debt by the bucket load, be exposed to losses on their sovereign debt holdings? If yes, will that leave Spain at risk from having to ask for more funds for their banks?

The latest Eurozone bailout highlights the toxic link between the banks and the sovereigns in Europe. Any bailout funds given to Greece will be rolled into Spain’s government debt burden and held on the sovereign balance sheet. IMF chief Christine Lagarde has pushed for Europe’s authorities to try and break this link at this week’s Summit, which has helped to keep Spanish ten-year bond yields below 7% after they surged to fresh record highs early last week. However, if Europe’s leaders fail to deliver the goods, we could see a sharp reaction in Spain’s bond market that could weigh on global risk appetite as we move into July.

NEXT: What to Expect from This Week's EU Summit

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What to Expect at This Week’s EU Summit

Italian prime minister Mario Monti has said there is a week to save the Eurozone. So what actions need to come out of the EU Summit for it to be deemed a success?

We believe the first thing that has to happen is a formalized softening of tough fiscal targets for the currency bloc. Thus, give Greece, Spain, etc. four years instead of just two to get their budget deficits down to 3% of the size of their economies. This doesn’t cost Germany anything and merely widens the economic goalposts.

Added to this, by lengthening the period of fiscal consolidation for an economy like Greece, it may reinforce the mantra of “living within your means” on the national consciousness and help to foster an attitude of fiscal responsibility. Due to these benefits, we see this proposal as has having a high chance of success.

There is also an immense amount of pressure on German chancellor Angela Merkel to widen the remit of the ECB so that it can act as a lender of last resort. This would give the ECB the power to print euro and bring its powers in line with those the Fed and the Bank of England already enjoy.

Because the ECB has a strict mandate not to intervene on behalf of governments, this would be a dramatic shift in the currency bloc and would mean that centralized Eurozone authorities could target members who are in trouble. This is a much harder sell to Merkel, as you can’t have the ECB printing money for every country that gets itself in trouble without protecting against moral hazard.

In return for the promise of indefinite “emergency” ECB liquidity, the union needs powers to collect tax from member states and control spending plans, which in essence is fiscal union. This could also lead to the Eurozone issuing debt under one entity, whereas now each country issues its own government bonds.

The chance of this being agreed upon this week is fairly slim. While we don’t expect full-blown fiscal union immediately after the Summit, it is likely that Germany will have to give some ground.

Essentially, if Europe’s leaders can agree on a compromise between providing more support for troubled economies and centrally managing national budgets, then we could come to some sort of compromise resolution.

Merkel is unlikely to take any steps that are not in Germany’s interest, but with pressure coming from within the currency bloc and externally from global authorities pressing for Europe to act decisively, it will be hard for her to ignore their calls. While fiscal union may not become a reality straight away, the market at least expects a roadmap to be put in place that could see the currency bloc strengthen its union in the next six months to a year.

The outcome of this summit could be critical for financial markets in the medium term. A disappointing outcome could see EUR/USD break below 1.2450 and head back towards the recent 1.2350 lows and then towards 1.20. However, if decisive, bold action is taken, then a march higher above the temporary top at 1.2750 towards 1.30 may be possible.

EUR/USD may trade between 1.2450 and 1.2750 as we lead up to the summit. EUR/GBP may also trade between 0.8010 and 0.8060, which is the base of the Ichimoku cloud chart and a major resistance zone. Until we get the outcome of the summit, the near-term direction of the euro is extremely cloudy, and we expect the market to consolidate at the start of the week.

NEXT: GBP Set-Ups That Could Unfold This Week

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Can the Pound Remain Resilient to More QE?

The minutes from the Bank of England policy meeting earlier this month confirmed that four members of the committee voted for more QE, although they were outnumbered by the five who voted to remain on hold. The minutes were deemed extremely dovish, as those who didn’t vote for more QE said there may be a need for it if the economy deteriorates further or if the sovereign debt crisis takes a turn for the worse in the coming weeks and months.

Thus, the market is now expecting GBP50 billion of QE from the Bank at its meeting on July 5. What has been interesting is the relative resilience of sterling to this news. Rather than cause it to drop off a cliff, as some would expect, the reaction in GBP was fairly muted, and on a broad-based basis, sterling was set to close last week relatively flat. In fact, against the yen, the pound managed to rally 1.5% last week.

So why is the pound able to brush off more QE from the BOE? There are a few reasons. The first is that this bout of stimulus has been well flagged up to the market in recent weeks after Mervyn King touted the possibility at the Mansion House dinner in the city earlier this month.

Secondly, the pound is still fairly weak against the dollar compared to levels it reached before the financial crisis in 2008, so sterling downside has been limited in recent years. Lastly, the amount of QE the Bank may do is fairly paltry at only GBP50 billion. The FX market has a turnover of more than $4 trillion per day; hence, QE of this size is a mere drop in the ocean.

We think that GBP/USD will end up being moved more by overall risk appetite than by policy actions from the Bank of England. Thus, we expect it to consolidate between 1.5500 and 1.5750 in the lead up to the EU summit.

A purer play on QE is EUR/GBP, especially since it seems the BOE will pull the QE trigger before the ECB. Above 0.8060 (the base of the daily Ichimoku cloud) could see this cross extend its recent rally.

See also: GBP Trade That’s Best When Risk Is on

By Kathleen Brooks of FOREX.com