Divisive Euro-zone politics will increase the threat that Spain continues to drags its heels on a bailout request while acrimony between Germany and France will intensify fears of peripheral revolt which will unsettle the Euro. The least-ugly contest should be won by the dollar this week with the Federal Reserve also under pressure to signal a shift in potential exit strategies and take a slightly more optimistic economic tone. The dollar backdrop is hardly a cause for inspiration and only a full-scale collapse in risk appetite is likely to trigger big US gains.
There was a semblance of EU Summit unity with a growing reluctance to let Greece default, but the reality of the overall situation is that divisions are widening. The German calculation at the moment, is still to do just enough to keep the Euro-zone together while refusing to countenance any radical shift in policies. Germany, for example, is continuing to back-track on a banking-union timetable. Crucially, there is no acceptance that the ESM should be used to support existing legacy debt which will continue to undermine the Spanish situation. If the Euro-zone was growing, this policy might just be sustainable, but the current political and economic trajectory is anything but sustainable.
In this context, the Euro-zone faces another extremely testing week with economics and politics set to play critical roles. As far as the economic data is concerned, the PMI releases will be vital on Wednesday with the latest German IFO survey due for release the same day. This data is critical as there is no hope of sustaining the Euro area if economies continue to contract rapidly. Last month, there were mixed readings for the data as a significant improvement in Germany was offset by a sharp deterioration in France.
This divide, if sustained, will have extremely important implications for the Euro-zone. There has been an increase in tensions between Berlin and Paris as the French government looks to exert greater pressure on the German administration to provide a greater boost to growth. Relations between Merkel and Hollande remain difficult at the best of times and there has been a clear increase in friction over the past few weeks. The body language alone between Merkel and Hollande ahead of the EU Summit should be enough to frighten markets. If there is a further deterioration in French PMI readings, there will also inevitably be a further increase in political stresses within a French government even more desperate to trigger a change in German policies. France will have to play a pivotal role in brokering consensus between the peripheral and core economies. If France weakens, there will be a much greater threat that the divide will become unbridgeable with severe consequences for the Euro-zone.
Wednesday's comments from ECB President Draghi will also be very important with a risk that he will issue thinly-veiled criticism of Euro-zone politicians. Any sign of serious tension would be very important in undermining wider Euro confidence.
The latest US Federal Reserve policy meeting will be held during the week with an announcement due on Wednesday. The impact will be less than that seen at the previous meeting, especially with no press conference from Chairman Bernanke and no updated forecasts.
Debate within the FOMC will still be extremely important and the key factor will be to see if the generally more robust economic data has triggered any change in sentiment within the committee. There will also be a close focus on a potential exit strategies and a change in communication policy, especially with increasing unease over the implications of stating that interest rates will be pegged at near zero for at least the next two years.
The US economic release calendar is likely to be dominated by Friday's GDP report with markets expecting a small recovery from the previous reading of 1.3%. In terms of importance, the durable goods orders data and latest jobless claims data on Thursday, together with the advance PMI reading on Wednesday, will be much more important for overall economic direction given their more forward-looking properties.
The latest UK GDP data will be released on Thursday and will certainly attract heightened interest this time around. There have been three successive quarterly contractions, pushing the economy back into recession. There were important doubts surrounding the accuracy of the data and there will also be important distortions this quarter due to the impact of the Olympics as well as a recovery from the holiday-related slide last quarter. Any growth of less than 0.5% would be another serious setback for UK sentiment.
Elsewhere, the China flash HSBC PMI index will be released on Wednesday and this will be an extremely important release for the global economy. There has been tentative hope that the Chinese economy has hit bottom and will show signs of recovery during the fourth quarter. This optimism will fade very quickly if there is further PMI deterioration for October.