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The talks have begun and speculation is building that Merkel and Sarkozy will come up with a credible plan for fiscal unity over lunch in Paris today. The success of this meeting and the ability of the French and Germans to bridge their differences will determine the success or not of the EU summit on Friday when the plan will be presented to other Eurozone members.
Steps towards fiscal unity is vital for resolving this crisis, not because it is the be-all-and-end-all solution, but because it is considered the pre-requisite before the ECB will step-up its bond purchases to try to stabilise the Eurozone debt markets in the near-term. As ECB President Mario Draghi said last week, there needs to be a fiscal compact before any other action can be decided.
Europe is dominating and speculation about this week's summit is in over-drive. Since markets work on much shorter time frames than the politicians in Brussels, the markets are rallying today on expectations that an agreement on fiscal unity will help to relieve pressure on Europe's sovereign debt market in the short-term.
Newspaper headlines this weekend were full of good market news: Firstly, reports surfaced that Europe is working together to solve this crisis and there is a potential EUR 1 trillion of new funds from the ECB waiting in the wings to stabilise the debt markets, secondly that the Fed is preparing to provide the IMF with more funding for the Eurozone. The market likes what it is hearing and stocks in Europe have opened higher, led by the European banking sector.
Italian bond yields have been a top performer today; yields have dropped nearly 30 basis points to just below 6.4% - well away from the 7.5% danger zone. This represents a 100 bp fall in Italian bond yields in just 5 trading days. Today's move is fuelled by the EUR 30 bn package of austerity measures adopted by the new government of Mario Monti over the weekend. This package is wide-ranging: it targets pensions and social welfare. The PM presents it to Parliament today at 1600GMT, who then have until Christmas to pass it into law. However, the austerity comes at the same time as Italy is forecast to fall into recession so there could be some difficulties finding the necessary support to get this passed, although that is not what the markets are focusing on today.
The dollar is getting hit today across the board as investors ditch safe havens in favour of risky assets. Added to that there is a rumour around the markets that the Fed could cut the discount rate (the rate at which it lends to US financial institutions) by 25bp later on today. This would bring Fed lending rates to domestic financial institutions in line with the rate it costs foreign banks to borrow dollars from the Fed. This has been expected since the coordinated central bank action last Wednesday and is likely to be mildly dollar negative as it boosts banking stocks and overall risk appetite even more.
We tend to think that markets will be range-bound until Friday. A good outcome from the summit - closer fiscal union and more short-term ECB action - will help markets rally into year-end and vice-versa.
EURUSD seems to be getting stuck at 1.3450, above here opens the way to 1.3480, then to the 1.3530/40 highs. Support lies at 1.3380. Likewise, GBPUSD is also range-bound, above 1.5660 opens the way to 1.5720/30 highs. The Aussie seems to be capped at 1.0300 - as we wait for the RBA meeting tomorrow. It is the first of the major central banks to meet today and the markets expect it to cut rates to 4.25%.
Eurozone and UK services sector PMI's were a mixed bag. Europe's services sector continued to stagnate in November, and it was revised lower to 47.5 from 47.8. There was some very bad news for Spain, its services sector PMI fell to 36.8, the lowest level since mid-2009. There was a pleasant surprise for the UK, its services sector continued to expand in November, the PMI rose to 52.1 from 51.3 in October, reversing some of the bad news from the manufacturing sector.
Kathleen Brooks| Research Director UK EMEA | FOREX.com
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