As the EU summit approaches the mood in the markets is getting jittery. The news last night that the EU was working on a three-pronged approach to dealing with the crisis lifted the mood in the markets after the scare from Standard & Poor's, who put 15 out of 17 Eurozone members on review for downgrade on Monday night.

The eleventh-hour plan is essentially a merger of the EFSF and ESM that could be combined to form the big bazooka that people are looking for. The plan to leverage the EFSF put together at the last summit at the end of October seems to have failed as there has been a lack of interest from foreign investors, so the ESM/ EFSF fusion is one alternative on the cards alternative, although France and Germany seem to be disagreeing on whether the ESM should be given a banking licence with France in favour.

The markets expect three things from the upcoming summit: firstly a commitment to fiscal unity from all 17 Eurozone members, secondly significantly more bailout funds and thirdly an enhanced role for the ECB. Essentially fiscal unity is the goal, but that takes time as it requires deep structural changes to the currency bloc and possibly even a Treaty change. So the ECB and more bailout funds need to be available to deal with the current problems while the politicians need to ensure that steps are put in place to prevent unsustainable debt levels form building up in future.

But are the markets too optimistic? We have been disappointed before and one day before the start of the summit a German official has been trying to dampen expectations by saying that they are more pessimistic than last week on finding an overall summit deal. The same official in Berlin said that not all EU states are aware of the situation's gravity hinting that there are divisions within the currency bloc at this 11th hour. This isn't what the markets want to hear, especially as a failure to act this week could cause a mass credit rating downgrade that could see Germany and France lose their triple A credit rating over the next 90 days and could also dent the rating of the EFSF rescue fund that issues bonds to pay for bailouts to Greece, Portugal and Ireland.

Added to this, Germany has also thrown cold water on the idea that the ESM and EFSF could run simultaneously thus thwarting an attempt to boost bailout funds - one of the key criteria that needs to be meet by Friday for this summit to be considered a success. This may be designed to lower expectations or it could suggest that the whole meeting is a damp squib.

This has taken the shine off the euro, which is back below 1.34 on the news, although 1.3370 is holding as good resistance. We are still very range-bound as we head up to tomorrow's ECB meeting and the EU summit. However, sentiment in the bond markets remains positive and Italian bond yields are still below 6% today. Added to that there was strong demand for a Portuguese and German debt auction earlier.

But if this positive sentiment is to continue it will depend on the outcome of the summit, so there could be some volatility in the next 48 hours in Europe.

The problem for traders today is that headline risks are building up. France and Germany are talking at odds to each other over the ESM/EFSF merger and before these big events hundreds of EU officials tend to crawl out of the woodwork and give their tuppence worth on discussions. Traders need to keep their heads clear and try and see through the noise. I believe that the euro wants to rally and if we see a positive outcome from the summit then we could see it bounce higher at the Asian open on Sunday.

Stocks are higher today even though they gave back some gains on the back of comments from that German official. Banks are higher, it was announced that there were $50bn of bids for ECB dollar funds today. This suggests that last week's coordinated central bank action is starting to give the banks much-needed liquidity. The markets are expecting the ECB to do the same for euro-based funding at its meeting tomorrow, so even with all the noise around the EU summit there is still some positive news for the banks now that central banks have stepped in.

Data Watch:

 

2100GMT/ 1600 ET: RBNZ official cash rate, 2.5% exp, 2.5% last

EU meetings and the meeting between US Treasury Secretary Geithner and French officials

Best Regards,

Kathleen Brooks| Research Director UK EMEA | FOREX.com

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