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Europe Whispers the Magic Words

I heard the magic words today from German chancellor Angela Merkel and French president Nicolas Sarkozy: “treaty changes”. That will be the gist of their joint proposal at the European summit this coming Friday to deal with the sovereign debt crisis.

To me, this means that the two besieged leaders are finally biting the bullet and laying the groundwork for the sweeping changes needed to solve their formidable financial challenges.

The plan will implement greater budget discipline with automatic sanctions for budget busters like Greece, who exceed the 3% of GDP deficit guidelines. Expect the European Financial Stability Council (EFSF) to move into action next year to help keep Greece in the monetary union.

You can also expect the European Central Bank to launch some fireworks this week. Among them will be:

1) ECB president Mario Draghi will cut interest rates by 25-50 basis points.

2) The ECB will relax collateral rules for borrowing banks.

3) It could also increase sovereign debt purchases of paper from the weaker countries, like Italy and Spain, from last week’s feeble $3.5 billion to as much as $20 billion a week.

The bottom line here is to expect a lot of “feel good” news flashes in coming days, which could cause the Euro to edge back up to the top of its current trading range at $1.3550.

But don’t hold your breath for any panaceas. The European treaty includes 27 members, with 17 employing the Euro as a common currency, and all have to agree to any changes. Substantial modifications will require national referendums. On top of that, Sarkozy is still blocking pan Eurobonds advocated by Merkel, which is the only supra national fund raising mechanism that can possibly work.

The reality here is that Germany is imposing austerity and fiscal discipline on the rest of Europe, and non-Germans may not necessarily like it. So the next wave of optimism is likely to once again bear the bitter fruit of disappointment, taking the beleaguered European currency down to $1.29 in Q1, 2012.

For those of you who have followed my advice to sell short the euro, there is an 800 pound gorilla in the room to deal with. The trading community is now short over 100,000 contracts in the futures market, an all-time high, matching the peak seen in the spring of last year, when the Euro just fell short of $1.60. The risk of a snap back rally going into the coming European love fest is high.

I have noticed that in recent weeks, the market is allowing the nimble ever smaller profits from their quick in and out trades. This may be a function of the declining volatility going into the holidays and the year end. So those with itchy trigger fingers may want to take profits sooner than they usually might and celebrate Christmas early. The value of dry powder is rising.