The Next Week Will Define The Eurozone's Future

 |  Includes: ERO, EU, EZU, FXE, IEV
by: Tim Clayton

It will be tempting to dismiss media hype and apocalyptic clichés over the next week, but the next 7 days really will define the eurozone future and inevitably also have a pivotal market impact. What has become abundantly clear is that time is running out rapidly as the European and, increasingly, international economies get sucked into a negative feedback loop.

The week will be characterized by rumours, political briefing and speculation as tensions build and meetings held. Market volatility will be high and the euro is likely to hit heavy selling pressure on significant rallies.

Although speculation has been denied, at least one major European bank was on the point of collapse before the central bank liquidity operation last week and the underlying situation remains perilous at best. Emergency borrowing from the ECB increased sharply on Friday, hardly a vote a confidence, and the global damage is also becoming severe. The shelf-life of half-baked solutions has also become shorter and shorter and the eurozone leaders have run out of road. A fudged solution will collapse within hours.

The eurozone in its current form will not continue beyond the next few weeks. The vital question is in which direction the new eurozone will take and what will it look like. Essentially, it does boil down to a choice between a redefined union with a pooling of fiscal and monetary power or, alternatively, the path chosen will lead to a smaller hard-core euro area.

The EU Summit concluding on Friday will certainly be extremely important and is likely to represent a key defining moment for the euro. The position ahead of the Summit is becoming increasingly clear. The German and French governments will effectively propose a rapid move to a much closer fiscal union.

If this can be agreed, then the trade-off will be that the German government will be more willing to provide additional financial support while the ECB will also provide increased monetary assistance.

The room for manoeuvre is now extremely narrow, especially given that market stresses have substantially cut any potential for leveraging the EFSF. Treaty changes will also be a major area of difficulty as there is very unlikely to sufficient time or political support for controversial changes while any attempt to by-pass parliaments will invite massive political protest and dissent.

German Chancellor Merkel may be committed to the concept of closer fiscal union, but she will find intense domestic opposition to any form of quantitative easing and there is a high risk that the Germans will call time on the EMU project by refusing to make major concessions.

There are a raft of central bank interest rate decisions and the final one of the week will certainly be the most important as the ECB gathers for its monthly meeting. For the other banks, the main agenda will be disaster-response preparation.

The Australian and Canadian rate decisions will be on Tuesday and the most likely outcome is that both banks will take a holding position. It would seem very unlikely that the Bank of Canada would consider changing rates for now. Following last month’s rate cut, there is a small possibility that the Reserve Bank of Australia will announce back-to-back cuts but, given that that last month’s decision was tight, it is more likely that rates will be left on hold.

The Bank of England monetary policy meeting on Thursday will certainly be a lively affair and there is also no doubt that there has been a quantum leap in fear surrounding the UK outlook over the past few weeks. There have been notably stark warnings from Governor King and other MPC members over the outlook. The recent comments also suggest that the bank expects further quantitative easing will be required. There does, however, appear little reason to play their hand early and the most likely outcome is that policy remains on hold.

The ECB meeting on Thursday is by far the most important, but the timing of the meeting is unfortunate for the bank. President Draghi, in an important speech last week, suggested that the bank would be willing to provide more support through monetary policy if there was a convincing political move to guarantee compliance on fiscal targets. The ECB hinted that it could step-up bond purchases if there were sufficient political guarantees.

The problem for the bank is that the latest EU Summit meeting will conclude after the ECB meeting. The ECB’s main task will, therefore, be to find a unified stance internally and also give the politicians greater guidelines on what they have to offer. This will be an extremely difficult task as there will certainly be a strong minority pushing very hard against any increased ECB support.

Similarly, the bank will either cut rates or indicate that rates will be cut again at next month’s meeting if the political back-drop appears favourable.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.