The outcome of the EU Summit was actually so bad that it's very hard to avoid the conclusion that the real agenda was actually to accelerate the formation of a new and smaller hard euro area. Putting those thoughts aside for now, leaders face an anxious period as key constituents deliver their verdict. For the plan to have any chance of success in keeping the euro together, the Franco/German alliance need several big decisions to go their way. If they fail, then the chances of avoiding a major euro break-up will continue to diminish. So far, the news has certainly been unfavourable with peripheral bond yields rising and the euro falling. The most likely outcome is that the Summit will be seen to have been a spectacular failure which will leave risk trades extremely exposed in the run-up to year-end.
A key voice will inevitably be the credit-rating agencies with a particular focus on Standard & Poor’s. Last week, the agency threatened to downgrade European sovereign nations and markets will be watching very anxiously to see whether this threat is carried out over the next few days. A decision to hold-off on downgrades would be an important boost for the German and French position while a downgrade would badly damage confidence. A two-notch downgrade for France would be an extremely serious setback both for France and the euro.
The European banking sector will also need to be watched extremely closely. The ECB decision to extend long-term repo facilities last week was an important step in easing funding stresses and allowing profitable carry trades to gradually restore profitability. There will, however, be a high risk that the damage sustained already will be too great to repair, especially as estimates of capital shortfalls are continuing to increase. If the banking sector continues to leak capital at an alarming rate, then the ECB operation will certainly not be sufficient to contain the damage. Confidence remains a vital and often intangible commodity. If there is a serious run on any of the major eurozone banks, then the implications will be devastating.
Peripheral bond yields will continue to be watched closely as a sharp rise would undermine sentiment. The ECB take will, therefore, also be extremely important given their potential impact on yields. At last Thursday’s monthly meeting, ECB President Draghi was keen to emphasis that the ECB was bound by its constitution not to provide deficit financing. IF the ECB maintains this stance, then the EU will be even more dependent on IMF-led support and internal financing. Leveraging plans are in serious difficulties and half-hearted IMF backing would be equally damaging.
The German Bundesbank will inevitably have a key role to play, especially given its opposition to ECB financing, major reservations to raising funds through the IMF and symbiotic relationship with the German government. German Chancellor Merkel will risk serious disarray if she attempts to over-ride objections.
The legal position will also need to be monitored, especially with rumblings that an inter-governmental conference approach would be unconstitutional according to German Law. It is possible that the UK government veto will actually sink the whole Treaty.
The EU electorates will also have an important say on matters even if the time frame will tend to be slightly longer. Sarkozy may have won some short-term relief by ensuring that the focus was on the UK, but the domestic political implications are very important. There will be a high risk that Sarkozy and his party will lose further momentum ahead of Presidential elections next May.
The eurozone economic data will also have to be watched very closely this week. The EU Summit provided no support whatsoever for growth with peripheral economies bound even more tightly to the shackles of deflation. If the PMI indices continue to deteriorate, then confidence in the economy will suffer another serious setback.
There were important political tensions within the euro states as well with Finland, in particular, very unhappy with the decision to make ESM bailout decisions on a majority vote. If Finnish and Dutch opposition hardens, then the deal could collapse rapidly.
The attitude of the remaining countries outside the euro area will also be watched very closely. The EU Summit briefings were very keen to play-up the idea that only Britain decided not to participate in the EU Treaty, but other key nations outside the euro area actually stated that they would need more time to study the details and implications. If Sweden, for example, decides not too embrace the Summit outcome then the deal could start to unravel.