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The financial markets desperately need a strong commitment from EU leaders to turn the tide in Europe. The hope now rests on this week's European leaders summit scheduled for Thursday and Friday of this week, June 28 and 29. There have been a number of side meetings between euro area finance ministers and EU leaders that has everyone hoping a major announcement is in the works.

However, we been down this road too many times before and are skeptical of whether or not European leaders have the political will to make the tough decisions that would end the crisis in Europe. What the market wants is a clear road map containing commitments of burden sharing across the region. Considering that as recently as last Friday German Chancellor Merkel refused to soften her stance on a number of key issues, we do not rule out the possibility of this week's meeting turning into another disappointment for the euro if EU leaders only vaguely allude to an agreement of a tighter economic union without providing any significant details.

What Europe Needs

  • Sharing of Sovereign Credit Risk Through Eurobonds
  • Prevention of Bank Runs Through Guaranteed Deposit Insurance

The only thing that could end Europe's crisis is a sharing of sovereign credit risk, because it is a lack of confidence in European assets that has led to a rise in bond yields and shut distressed nations out of the credit market. Germany would effectively have to lend its AAA rating to the rest of the region, making it financially responsible for defaults of weaker nations. For investors, this provides a huge boost in confidence because German taxpayers will now assume the default risks of Greece, Portugal, Ireland, and Spain. That means if investors buy their bonds, the chance of their money being returned increases significantly. By default, this would give individual nations better access to the credit market and bring their yields down to more manageable levels.

So how can this be done? The strongest response would be eurobonds -- instead of individual nations borrowing on their own at varying interest rates, the euro area would borrow together as one unit. In other words, Greece would be paying the same interest rate as Germany. In order for this to work the yields on eurobonds would have to be higher, which means Greece would pay less but Germany would pay more. As you can imagine, asking German taxpayers to assume more responsibility for their neighbor's problems is not sitting well with Merkel or her constituents.

Another option is guaranteed deposit insurance, which helps to prevent a bank run but would still cost German taxpayers if savers in Greece and Spain continue to take their money out of local banks and move them to German banks, leading to a liquidity crisis in those nations. Eurozone bailout funds can also be lent directly to banks, but there is little support for this from the Germans. While none of these options will nurse Europe back to full health, if combined with the growth package proposed last week, it can go a long way in setting the course for recovery.

What EU Leaders Will Deliver

  • EUR130 billion Growth Package
  • Tax on Financial Transactions
  • Single European Banking Supervisor

What Europe needs and what EU leaders are prepared to deliver are two completely differently issues. Europe's leaders are still playing politics with economics and until they are ready change, Europe will not get the solution that it needs. With this in mind, we know there will be at least two major announcements at the end of the week: a EUR130 billion growth package and a financial tax that would be used to pay for future bailouts. Both of these measures were agreed to at the four-way summit between German, French, Italian, and Spanish leaders last week. While sovereign credit risk is important, supporting growth is also a critical step to turning Europe around because at the end of the day, the real problem in all of these countries is the high level of unemployment.

Details on what the growth package will include should be shared this week, along with the announcement of a Tobin tax, which is tax on financial transactions (sale of stocks, bonds, and derivatives) that help to raise money for the governments and for future bailouts. The U.S. and U.K. oppose the tax on a global level because they believe it is counterproductive. Nonetheless, it appears as f the EU will confirm that it is moving forward with this at the end of the week. There should also be plans to form a single European banking supervisor that oversees the region's biggest banks. EU leaders want as many quick wins as possible, and all of these proposals can be implemented quickly without requiring a change to the EU treaty.

The German chancellor will be heavily outnumbered at the EU summit, but she holds the purse strings and getting her to concede will be difficult. Merkel is not completely against the idea of sharing sovereign risk and forming a fiscal union in the eurozone in the long run, but she prefers that it doesn't happen on her watch. The cost of a fiscal union is sovereignty, which other nations may not be willing to concede. National governments would have to give up some fiscal and political authority, surrendering, say, on their budgets and transferring their money from stronger to weaker nations -- similar to the way that richer nations finance poorer states. The idea of German tax revenue being transferred to Greece to fund that country's social welfare programs is deeply unpopular in Germany, especially in this current economic environment where every country is fighting for economic survival.

Impact on the EUR/USD

  • EUR/USD Will Make a New Year-to-Date Low if EU Leaders Fail to Send a Convincing Message That Fiscal Union Is in the Works
  • Then It Is All in the Hands of the ECB

With this in mind, European leaders realize that expectations are high for this week's EU summit. Aside from a program to promote growth and a financial tax, EU leaders need to send to send a convincing message that a fiscal union is in the works. If they fail to do so, investors will take their disappointment out on the EUR/USD, European bonds, and global equities. But if the Germans are willing to open up their pocketbooks and lend their credit quality for others to use, the EUR/USD will likely soar toward 1.30 in celebration.

However, the chance of this happening is slim because, according to a Merkel aide, "many countries have still not come to grips with the idea of moving toward greater fiscal integration." Therefore, we expect this week's EU summit to be another major disappointment for European investors. Then it will be up to the European Central Bank to stem the turmoil in the market by introducing another round of stimulus, either in the form of another long-term refinancing operation or a reduction in interest rates in July.

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

Source: Will EU Leaders Successfully Repair Europe?