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Markets expect the euro to spike higher and peripheral yields to drop sharply once Spain requests a sovereign bailout. As long as the illusion of unity within the eurozone can be sustained and the phony war continues, these expectations will help keep euro selling at bay, given the risk of sudden and aggressive moves against short positions. The degree of economic, political and social damage is, however, continuing to escalate with unemployment at intolerable levels. Even if fragmentation can be kept at bay, and this looks increasingly unlikely given the increasingly hard-line stance in countries such as Finland, the ultimate cost is likely to be a sharply weaker euro over the medium term.

In this context, its very difficult to justify buying the euro above the 1.30 level. If Spain threatens the nuclear option of attempting to blackmail the rest of the euro members into providing better terms for a bailout, all bets will be off, the Euro will weaken sharply, and the dollar will gain an important reprieve.

With a shortage of potential market-moving economic data, the focus during the forthcoming week will certainly be on international meetings. The Eurogroup meeting of eurozone Finance Minister will be held on Monday in Brussels, followed by an ECOFIN meeting of all EU representatives on Tuesday. There has been a determined downplaying of expectations ahead of the meetings. There are expectations that the Greek troika report will not be ready in time for the meeting, and there were a series of comments on Friday that a Spanish bailout request was not imminent.

Regardless of the exact timetable, Spain will, inevitably, be an extremely important focus of attention during the meeting and throughout the week. The complex political dance between all major parties will continue to be a key focus until there is some form of resolution.

The economic situation within Spain is increasingly toxic, and there will be substantial political demonstrations during the week, with unions also threatening a general strike. Spain may be able to play for time, but there is little chance of a sustained holdout, especially as the banking-sector support through the ESM appears unlikely to be available until 2013.

Spanish government ministers have continued to insist that they have not yet made a decision on whether or not to apply for sovereign aid through the ESM. The timing is particularly crucial, with the ESM set to come into operation on Monday and its first meeting due to be held on the same day.

The German Finance Ministry has indicated that it does not want Spain to request a bailout at this stage. Officially, this is because it considers that Spain does not need a full bailout. Unofficially, Chancellor Merkel is extremely uneasy over the political risks of having to apply for Bundesrat backing for bailouts for Cyprus, Spain and potentially Slovenia, as well as any fresh loan support for Greece. The German government wants the loan-support packages to be rolled into one in order to minimize political damage.

The main fear within Spain now appears to be the scenario where a request bid is rejected. As well as being politically humiliating, it would destabilize the bond markets and plunge the eurozone into fresh crisis. There has been a sharp decline in short-term bond yields within peripheral economies, with reports of hedge fund inflows into Spanish and Italian bonds on the basis of expected ECB bond buying. If the ECB is unable to find the conditions to start the program, the international reaction will be extremely negative.

Annual meetings of the IMF and World Bank will be held on October 9-14. During that meeting, there will be a G7 meeting on the 11. Ratings action will also be an important focus, with Moody's still deliberating over its Spanish rating action.

The major fundamental battle is likely to be between growth differentials and medium-term fundamental concerns. The dollar will gain support from expectations that the U.S. economy will outperform, certainly in comparison with the eurozone, but the Federal Reserve quantitative easing program is a constant negative for the U.S. currency. Unless risk appetite deteriorates sharply, the U.S. currency will struggle to make much headway.

The U.S. data releases are not likely to have a major impact. The latest trade data will be released on Thursday, and the volume of trade flows will be watched closely given unease over the global trade and growth outlook. The latest jobless claims data on Thursday will be followed by the University of Michigan consumer confidence data on Friday. Politics is likely to dominate, and the Fed is likely to be subjected to further criticism of its move to expand quantitative easing following the unemployment data. The Fed also risks being dragged into the political debate, which will undermine medium-term credibility.

The performance of Chinese markets and potential economic responses will be watched very closely as China returns from the one-week holiday. Any renewed downward pressure on the Shanghai market would inevitably undermine global risk appetite.

Source: Weekly Forex Preview: Phony War Protects The Euro Only Short Term