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The markets are playing a cautious game at the start of this pivotal week for the markets. The EU summit is the event everyone is waiting for and anticipation for long-term closer fiscal unity opening the way for more ECB action to stabilise Europe's debt crisis in the shorter-term, is growing. Since e we have been at this spot before, the markets are no doubt worrying about stray headlines dashing hopes and causing this risk rally to do an about-turn.
But while our hopes have been dashed before, this time it feels different. Europe's leaders are talking about structural changes to the Eurozone and the market likes what it hears. The Eurozone is no longer fit for purpose in its current form. As populations age in the currency bloc, tighter fiscal rules are necessary to keep debt levels on the straight and narrow. Thus, markets are reacting positively to expectations that a centralised budget committee of sorts will control countries' spending patterns in future, hopefully averting a crisis like this from ever happening again.
The markets have been blamed for forcing Europe's leaders to act hastily, but this is the wrong analysis. Bond investors have shunned European debt because the model no longer works, it won't get back into it until Europe's leaders have come up with an alternative.
This is a pivotal moment for the currency bloc- the Eurozone is getting a chance to re-invent itself and that should not be wasted, change is good and can bring with it great opportunities. But first we need Europe's leaders to take bold decisions this week then national politicians need to support these decisions instead of resisting change. This could be a bright new beginning for Europe and should be embraced.
Italy's Welfare Minister Elsa Fornero may have cried at the extent of Mario Monti's budget reforms, which includes far-reaching changes to Italy's pension system, but she still supports them otherwise, as Monti said, Italy could collapse bringing the whole of the Eurozone with it. The markets like tax and pension reform especially if it will help to bring Italy's budget back into balance by 2013. The good thing for Italy is that its budget deficit is only 4.6% of GDP, so a few years of austerity will bring its finances back into the black. Since markets like swift action, this is having a very positive impact on Italian bonds: Its 10-year bond yield has fallen 60 basis points today, nearly 150 basis points in a week. This is a spectacular recovery.
The markets are reacting to the government's determination to get Italy's finances back on track, but this is no easy task. Growth is expected to stagnate next year and Monti's government is unelected. If it can't push this austerity programme through Parliament before the Christmas deadline then we could see sentiment towards Italian debt start to dip once again.
Italy is not the only country with a tough budget, Ireland's Prime Minister will announce another EUR 2.2bnof public sector spending cuts later this week, the third year of austerity, and likely not to be the last.
So the members' states are holding to their end of the bargain of implementing far-reaching fiscal reform, where do the EU authorities stand? So far so good. A government spokesman and ally of Chancellor Merkel said her Christian Democratic Union party won't stand in the way of the Bundesbank channelling funds to the IMF to lend to struggling member states. He also said that the Party would be really pleased for the IMF to take on a bigger role in fighting this crisis. This is important since Europe's central banks can't offer loans directly to governments, using the IMF as a go-between gets around this problem and also alleviates stress in the bond markets straight away. Germany remains firm in its belief that private sector bond-holders need to share I the burden of bailouts from 2013 - we need to hear more details on this as it has the potential to dent sentiment but for now the markets are okay to ignore pesky details.
Risk is back on as we Sarkozy and Merkel give a press conference. They are both talking on the same page; even Sarkozy has taken the German line and said there can be no Eurobonds. Merkel is calling for closer fiscal unity and that the aim is to bring the ESM (the long-term replacement to the EFSF) forward to 2012.
Geithner flies into the fray tomorrow to meet with Europe's leaders ahead of this critical summit. No wonder since the US wants Europe's crisis to stabilise to protect growth (and too much talk about US debt levels) as we lead up to Presidential elections next year.
Economic data was also in focus today. Eurozone service sector survey data was resolutely bad. However, the UK data surprised to the upside. Its service sector PMI saw modest growth in November to 52.1 from 51.3 in October. The detail of the report was mixed: new orders were weak, while business confidence was high in the service sector in the lead up to the Olympics next summer. However, as new business falls off firms are cutting workers, which tempers the good news since it could point to continued stresses in the labour market and more pressure on public finances as the unemployment benefits bill continues to rise.
EURUSD is stuck in a tight range, trading between 1.3380 and 1.3450, however it likes what it hears from Merkel and Sarkozy and above 1.3480 opens the way to the prior 1.3530/40 highs. However, watch out as gains towards 1.35 may be faded until the end of the week. Stocks in Europe look good, and are being led higher by the banking index. In the last 10-days Societe Generale's stock price has risen by 30% as investors expect EU leaders to deal with bank re-capitalisations this weekend also.
So there is a long list of things to address at this week's EU summit, expectations are high, but right now the market believes that we are moving towards a conclusion.
Kathleen Brooks| Research Director UK EMEA | FOREX.com
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