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The euro/USD (NYSEARCA:FXE) was up slightly last week despite weakness in the European sovereign bond market. However, the big news in global markets came from outside Europe. Investors were focused on comments from Federal Reserve Chairman Ben Bernanke about the possibility of tapering QE as well as the jump in Japanese bond yields and weakness in the Nikkei (NYSEARCA:NKY). The move in European sovereign bonds seemed to follow similar moves in Japan and the US and does not seem to reflect European specific issues. Going forward, I expect the euro and European assets to be mainly driven by the increasing likelihood of further action by the ECB, which may coincide with the Fed's tapering. This could result in a weaker euro and stronger European equities (and possibly bonds).

ECB Watch

Pimco recently came out with an interesting analysis of the dynamics in Europe: How to Turn the ECB Straggler into a Central Bank Pacemaker.

For a while I have been talking about the fact that the ECB is losing the race at the printing press relative to the Fed and Bank of Japan. Pimco's analysis gives some interesting statistics about this dynamic:

"The U.S. Federal Reserve (Fed), Bank of Japan (BoJ) and Bank of England (NYSE:BOE) have all been heavily engaged in asset purchases. The European Central Bank (ECB), in comparison, looks like a shrinking violet. As of 13 May 2013, the Fed's and BoJ's balance sheets have grown year-to-date by 14% and 10% respectively; the ECB's balance sheet actually fell by 14%.

How central banks use their balance sheet is also important: Asset purchases are 10% of the ECB's balance sheet, but 97% of the Fed's. The ECB has provided funding support but, in contrast to the Fed, has transferred much less risk from investors' balance sheets. The result is that it has done less to help banks deleverage, improve their capital ratios and hence increase their willingness to lend.

Investors should be wary of extrapolating this status quo - Europe's weak economic outlook means that we should expect the ECB to become more, not less, engaged."

The dynamic of the ECB becoming more active at the same time as the Fed potentially tapers QE could weaken the euro.

Euro Price Action

The euro closed above the key $1.29 level that I have been watching for a while.

The fact that the euro was slightly up while European bonds sold off suggests that the move in the European bond market was driven by factors outside of Europe.

(click to enlarge)

(Source: FreeStockCharts.com)

European Sovereign Bonds

European sovereign bonds were down across the board as yields rose and spreads widened. I suspect that the European sovereign bond market was reacting to the action in the US and Japanese bond markets.

From a big picture perspective, yields on peripheral bonds have come way down since the extreme levels of last summer. It is important to watch for a reversal of this trend, but the action last week is not enough to suggest a major reversal just yet.

(click to enlarge)

European Equity Markets

I noted previously the divergence between the performance of European equities and the euro, but both were rather steady last week.

EZU Chart

EZU data by YCharts

The major European indices were down slightly last week with Spain lagging its peers again.

The following chart shows the five-day price action for the iShares MSCI Germany Index Fund (NYSEARCA:EWG), iShares MSCI France ETF (NYSEARCA:EWQ), iShares MSCI Italy Index Fund (NYSEARCA:EWI), and iShares MSCI Spain Capped Index Fund (NYSEARCA:EWP), and the SPDR EURO STOXX 50 ETF (NYSEARCA:FEZ).

EWG Chart

EWG data by YCharts

On a year-to-date basis, Germany and France are outperforming while Spain and Italy are hovering around breakeven.

EWG Chart

EWG data by YCharts

European financials lagged the broader index last week.

The following compares the iShares MSCI Europe Financials ETF (NASDAQ:EUFN) with the iShares MSCI EMU ETF (NYSEARCA:EZU).

EUFN Chart

EUFN data by YCharts

I have a position in Banco Santander (NYSE:SAN) as a play on European banks. Banco Santander traded in-line with the European financials last week.

SAN Chart

SAN data by YCharts

Recently, Spanish officials announced new loan provision requirements for Spanish banks.

However, it seems that Banco Santander will not be impacted:

""We think the impact will be between €5B and €10B," the Bank of Spain tells FT, in the first official estimate of the additional provisions Spain's banks will need to take against bad loans as the government prepares to do away with "extend and pretend." Although the extra provisioning will no doubt weigh on results, expectations are that Banco Santander and BBVA will have no trouble absorbing the hit, though it isn't clear that the same can be said of smaller banks." (Source: Seeking Alpha)

Here is a closer look at Banco Santander.

(click to enlarge) (Source: FreeStockCharts.com)

Impact of European Equity Markets on U.S. Equity Markets

Earlier this year, European equities lagged their US peers. However, they are catching up and basically traded in-line with US equities over the last three months.

The following compares the S&P 500 (NYSEARCA:SPY) and the Financial Select Sector SPDR ETF (NYSEARCA:XLF) with their European counterparts, the EZU ETF and the EUFN ETF.

SPY Chart

SPY data by YCharts

Conclusions

European assets seemed to be reacting to external news last week. European sovereign bonds declined, but this seemed to be a reaction to movements in the US and Japanese bond markets.

The euro was slightly up on the week. Going forward, I expect the main driver for the euro to be the increasing likelihood of ECB action as well as tapering by the Fed. This dynamic should lead to a weaker euro, but could be a positive catalyst for European equities.

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Source: Euro Steady Despite Bond Weakness, But ECB Is The Next Big Catalyst

Additional disclosure: I am long put options on the SPY that stand to rise in value if the SPY declines. I may trade any of the securities mentioned in this article at any time, including in the next 72 hours.