E.U. summit deal doesn't solve European debt crisis

Market reaction is puzzling

Despite the disappointment over the EU Summit felt by most market observers, risk markets managed to rebound on Friday. For the week, EUR/USD was essentially unchanged, not the result one would expect given the risks still facing the single currency. Other risk assets (e.g. AUD/USD, EUR/AUD, NZD/USD, S&P 500, and crude oil) finished the week either unchanged or nearly so, suggesting that risk sentiment remains uncertain and still undecided. Italian and Spanish government bonds, however, show clearer indications of a rejection of the past week’s attempts to rally, suggesting prices may fall again and yields may surge higher.

It may be that we’re facing another Wile E. Coyote moment, where markets have gone off the cliff, but haven’t looked down yet. There may also be a growing resignation that the worst case scenario of a Eurozone break-up will not ultimately come to pass, or that the hodgepodge of lending facilities the EU/IMF has come up with will together be enough to prevent a sovereign debt collapse. Or that they have bought themselves some more time, postponing the day of reckoning once again. Word on Friday that China has initiated a new $300 bio investment vehicle, with half destined for Europe/half for the US, was the proximate catalyst for the risk rebound on Friday, which may not prove sustainable. For the EUR in particular, the ECB’s refusal to commit to using its balance sheet on a larger scale (turning on the printing presses) to support EU debt markets is certainly helping to limit the downside.

Whichever flavor one chooses, there is a growing risk of a capitulation in risk-off positioning, meaning a potentially sharp rebound in EUR and risk/sell-off in USD, likely exacerbated by lower year-end liquidity and market interest. We would highlight the 1.3500/3600 area in EUR/USD as a potential trigger to a short-squeeze higher. Alternatively, a drop below 1.3150/200 would suggest markets are experiencing more intense risk aversion on deteriorating fundamentals and may see risk assets decline into the end of the year. In the meantime, inertia within recent ranges should continue to prevail.

Next page: Risks remain

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