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See part 1 of this article here.

Last week showed once again that markets can and do discard longer term fundamental realities for the sake of playing expected political decisions to defer crisis as long as possible. Perhaps this is indeed wise, for the delays are allowing banks and governments time to devise a plan to shore up EU banking an prevent a panic when Greece and possible others default.

Here’s what we see as next week’s prime market drivers.

Ongoing Greek Drama

Europe remains the source of the most immediate threats to market stability. The recent Finmins meeting couldn’t get an agreement and so pushed it off for a month, until just days before Greece faces default. See part 1 for a review of just some of the challenges facing the EU.

Finland’s Finance Minister Jutta Urpilainen doesn’t see a solution to her country’s demand for collateral for rescue loans to Greece coming out of today’s summit in Poland. Her country’s demand for security has triggered similar requests from other states and threatened to scuttle the second bailout deal. Yet Greece could never afford to provide cash collateral all the seekers the move would provoke. Can discipline be imposed on Finland? Surely the Finns realize that their demand forcollateral provokes others to seek similar concessions from Greece that Greece cannot afford, thus risking killing the patient with the supposed cure.? If not, because Finland’s contribution to the rescue package is small, can the bailout proceed smoothly without Finland.

The European debt crisis remains a major uncertainty for global financial markets with a Greek default becoming more a question of when and how orderly (not if) for reasons cited in part 1. At the start of the week Greece’s 2-year yields above 76%, several peripheral yield spreads over Germany at their highest levels, and record high 5-year CDS for Spain, Italy, Portugal, Greece, France, and Belgium. As a result of continued commitment by EU officials to implement the July 21 agreements which eased worries of an imminent Greek default, financial stresses in the eurozone have receded with Greek 2-yr yields testing 50% Friday as well as yield spreads and CDS tightening. Angela Merkel said that Germany has a “duty” to help secure the euro’s future in an attempt to ease markets.

European finance ministers have gathered in Poland for the start of this weekend’s EcoFin meeting to discuss the EFSF, Greece aid, and a collateral deal. The market remains skeptical on a tangible outcome which has put pressure on the common currency. EUR/USD was rejected from the 38.2% Fib retracement of the decline from the highs above 1.4550 to the near 1.35 lows and the pair is currently trading around the 1.38 figure. Also weighing on the euro is the shift in stance by the ECB. The bank has turned more dovish noting that the risks to growth are to the downside and inflationary risks are no longer to the upside. In the week ahead, Europe will see PMI’s out of Germany, France and the eurozone to give indication on the state of the economy in the region. The market is also keeping a close eye on Italy’s Aa2 credit rating as Moody’s placed Italy on watch negative three months ago today.

Key technical resistance in the EUR/USD is around the 1.4030 zone which is where the 50% Fibonacci retracement of the previously mentioned move comes in as well as where the 200-day simple moving average lies. Additionally, the 200-week SMA is currently around 1.4015 .

Speculation & Reaction Regarding Expected Fed Stimulus

The Fed has extended next week’s FOMC meeting to 2 days in order to have adequate time to discuss monetary policy as several options are available to the committee.

The meeting will start on Tuesday, September 20, and continue through the next day, when a policy decision will be announced at 2:15 PM ET.

In a proposed Operation Twist, the Fed would purchase 7-10 year notes (and maybe even longer-term bonds) by selling short-term securities in the hopes that this would drag down long-term interest rates.

Discussion of this plan suggests deep fears about the weakness in the housing sector.

Here are a few perspectives:

From Fed Chairman Ben Bernanke earlier this month:

The housing sector has been a significant driver of recovery from most recessions in the United States since World War II, but this time–with an overhang of distressed and foreclosed properties, tight credit conditions for builders and potential homebuyers, and ongoing concerns by both potential borrowers and lenders about continued house price declines–the rate of new home construction has remained at less than one-third of its pre-crisis peak.

From Deutsche Bank:

We believe the Fed wants to look as proactive as possible in trying to get the economy to improve. Most policymakers on the Committee are of a dovish inclination, and they believe that substantial economic slack will limit any sustained rise in core inflation. We sense that the consensus believes further accommodation poses little near-term risk to the economy. Consequently, the FOMC will continue to err on the side of doing more not less.

From Morgan Stanley:

Double-dips have only occurred upon Fed tightening: Whenever in post-war US history expansions have died young, the catalyst has been monetary policy tightening. Put differently: double-dips have occurred only when induced by the Fed…In the US, the Fed will not only remain supportive but is expected to loosen monetary policy further.

From Nomura:

We think the market will be disappointed by relative inaction. Given that the Fed acted through communication strategy in August (the last FOMC meeting) and that the Obama jobs plan is still being discussed, we see no reason for the Fed to feel compelled to act. We would expect risk assets to sell off in that scenario as well, as they have bounced off recent lows, despite the eurozone turmoil.

Either way, attention remains focused on Europe. Fed Chairman Ben Bernanke warned in his statement last month that political inefficiency in the U.S. could hinder market growth, but the focus of both FOMC and investor anxiety has centered around fears of a global economic slowdown.

That was evident in the FOMC minutes released after last month’s meeting.

In sum, there is plenty that could potentially move markets.

The FOMC pledged to keep rates lows through 2013 and the committee will announce its decision on policy at the conclusion of the 2-day meeting on Wednesday September 21. With the rising CPI figures released this week – headline CPI rising to 3.8% y/y from the prior 3.6% and the core reading climbing to 2.0% from the prior 1.8% – it is highly unlikely that the Fed will announce QE3. The market is largely expecting the next move to be a shift in the duration of the Fed’s current holdings which would be less bearish for the USD than outright asset purchases.

The so-called ‘Operation Twist’ would see a flatter yield curve with the short end of the yield curve moving higher while longer dated yields move lower. Should this scenario play out, we would expect to see little impact on the dollar. A dovish policy statement is likely to see the dollar correct lower but the USD bias is higher while the dollar index remains above the top of the daily ichimoku cloud which is seen around 75.00.

The most visible impact in the FX markets may be seen in USD/JPY because the pair has been highly correlated to yields. A rise in short term Treasury yields would be supportive of USD/JPY and may see the pair advance. Japanese officials have been vocal about the strength of the yen and its negative impact on economic activity with the markets on alert for intervention. In our view, we anticipate the BOJ to stay on the sidelines ahead of the Fed decision.

Brewing US Budget Fight

As noted in part 1, the US faces yet another potentially damaging budget fight as it needs either a budget or extension measure to keep the Federal government in operation. The debt ceiling battle eroded Washington’s credibility to deal with its debt issues in an responsible manner badly enough to lose its AAA rating. The approaching battle could both scare markets and further erode the USD’s value.

Top Calendar Events Next Week

  • Monday: None
  • Tuesday: AUD monetary policy meeting, EUR German ZEW economic sentiment USD building permits, Fed Begins 2 day extended policy meeting.
  • Wednesday: GBP MPC meeting minutes, public sector net borrowing, CAD CPI, USD existing home sales, FOMC statement
  • Thursday: CNY: HSBC Flash Mfg PMI, CAD retail sales, EUR series of French and German flash Mfg and Service PMIs USD weekly job first time claims
  • Friday: IMF Meetings, Trichet Speaks

Disclosure/disclaimer: No positions. The above is for informational purposes only. All trade decisions are solely the responsibility of the reader.

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