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The week ahead is likely to be dominated by issues of trust or, to be more precise, a lack of trust with the banking sector likely to be a key focus. If funding pressures cannot be alleviated, there will be the growing threat of a major European bank failure which would put risk appetite under severe pressure.

The EU Summit has to be one of the most bizarre in recent memory. Leaders may be relieved that they have managed to get through this exercise without causing a market meltdown, but it is very difficult to believe that the key players actually think that they have improved the eurozone outlook.

The Summit was fundamentally a political exercise as this was the only way to cover-up the lack of any real achievement and prevent an even deeper political crisis for the French President. The UK provided a very convenient political smokescreen as the decision to effectively force the UK to reject a new Treaty dominated the headlines and was a welcome distraction from the lack of substance and French concessions to Germany.

German Chancellor Merkel has bought time domestically and the electorate may be more willing to back her on more fundamental concessions in the future and this is probably the most tangible area of success for the Summit, but the cost may prove too high. The political reactions in Finland and the Netherlands will be watched very closely. Their governments are extremely angry that ESM bailout decisions will be taken on a majority vote. Could this be the straw that breaks Helsinki’s back and pushes them to rejecting the EU Treaty and the Euro?

The IMF and ECB will inevitably be extremely important over the week. The ECB has committed itself to providing increased support for the banking sector via liquidity operations, but not offered any concession on sovereign debt. Markets will need to watch comments from key officials very closely to assess whether there will be a change of tone. The media want to take it to a binary stance and it will be a case of ECB rescue or bust. Similarly, comments from the IMF on potential support will be watched closely and it will be very important to read between the lines. Actions by ratings agencies will also be very important for market sentiment.

There is still very little confidence surrounding the banking sector as funding conditions remain extremely tight with much of Europe shut-out of wholesale markets. There is a growing lack of collateral which can be used to access funding which is making banks even more concerned over potential counter-party risk and triggering a further cut in credit lines. There looks to be little reason for any improvement in trust in the short term and rumours of a major bank failure will continue.

The simple truth is that the genie of possible break-up is out of the bottle and it will be extremely difficult to get it back in again. There have been further reports, for example, of companies shifting funds out of the peripheral economies and into the German banks. The logic is obvious as there is no downside risk to moving deposits out of Spain and Italy. Whatever happens it is very difficult to see how they could manage to revalue their currencies so there is no benefit to leaving funds where they are. This logic will become increasingly clear and the exodus of capital could easily become a torrent. Such a flood would also further weaken the banking sector.

Capital controls will be a significant focus during the week as governments will be looking at measures to prevent an exodus of capital. In a similar vein to attempts at banning short selling, legislation might initially slow the rate of capital outflows, but such a move would also guarantee that the eurozone will break apart.

The Swiss banking sector will inevitably be an important conduit and destination if trust continues to deteriorate. In this context, the National Bank monetary policy meeting will be very important on Thursday. There will be the possibility of further action to prevent franc appreciation and the general tone of comments will also be very revealing on their state of anxiety.

The Federal Reserve will hold its final FOMC meeting of the year on Tuesday amid continuing tentative evidence that the US economy is making some headway. There appears to be very little case for policy action at this time and the principal focus is likely to be contingency planning in case the eurozone implodes over the next few weeks.

As far as economic data is concerned, the most important releases are likely to be the flash PMI readings on Wednesday. The eurozone readings will give a very important indication of the likely European trajectory for the first quarter of 2012. Stabilisation or any improvement would increase the chances of some respite while any further deterioration would trigger forecast of deeper recession.

China’s HSBC PMI flash manufacturing report will also be very important in a global context. There have been increased fears over a hard landing in China’s economy and any further deterioration in the PMI index would be a worrying development. It would also increase the focus on domestic economic management and talk of an investment fund to rescue the eurozone would be likely to fade from the headlines.

Source: Weekly Preview: Banking Sector Holds The Key