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At an unscheduled news conference early this morning the EU President announced sweeping changes to Europe's bailout facilities in an attempt to ring-fence Spain and Italy from the bond vigilantes' grip.
Risk assets loved this announcement and the euro jumped nearly 200 pips on the news. European stock futures are also poised to open sharply higher.
The main changes are:
1, Bailout loans to Spain's banks won't have seniority status
2, Bailout funds (EFSF and ESM) can be tapped by Eurozone countries to help reduce their borrowing costs even if they have not formally signed bailout programmes.
3, Ireland's bailout package is likely to be renegotiated.
4, The shift to more flexible bailout funds won't be put in place until there is a Eurozone wide banking supervision authority that the EU Commission has until the end of the year to prepare.
What does this breakthrough do?
1, Eurozone authorities have attempted to break the toxic link between banks and sovereigns. The move on Spain is extremely positive in our view. Although it doesn't irradiate the problem of bad loans on Spain's banks' balance sheets it does mean that banking debt won't clog up Spain's sovereign balance sheet that was relatively healthy before the banks started to fail. This should reduce Spain's borrowing costs in the short to medium term.
2, It shows that the Northern bloc of countries led by Germany, who had been against allowing the ESM to buy sovereign debt, is willing to give up some ground as the EU tries to solve this sovereign debt crisis. The move on scrapping credit seniority for bailout loans to Spain's banks is a very positive move to us as it encourages the private sector to invest in Spain and Italy's sovereign debt. Only yesterday the Finnish PM spoke out against this....
4, But Germany and co. won't be hoodwinked at this summit. A central banking authority marks a big change for Europe. It scraps the 17 individual authorities and should help enforce re-capitalisation rules across the continent and allow European banks' capital levels to get up to the same levels as their US counterparts.
5, A banking union could be a pre-curser to fiscal union, which many people think is the only way to save the currency bloc.
What are the drawbacks?
1, the EFSF/ESM rescue funds only have EU 500bn of available capital, yet the total liabilities on Spain's and Italy's balance sheets' top EU 2.4 trillion.... This could curb the market's enthusiasm as we haven't heard any signs that these bailout funds will be topped up.
2, Timelines: things in Europe tend to take forever, and a single bank supervisor could take more than 6 months to implement, which could delay the proposed changes to Europe's bailout funds.
This move is risk positive, which is good for commodities, stocks, the euro and commodity currencies. It may reduce demand for safe havens like the dollar and the yen. The EURUSD had a sharp move higher in the Asian session and investors are holding their breath as we wait for Europe to come into work. 1.2630 is the top for now. Looking ahead, we have seen the euro rally when credit risk in Europe's periphery is reduced. Thus, look to the Spanish and Italian bond markets for more direction.
We think this action, although not the end of the road for the sovereign debt crisis, will help to ease sovereign strains in Italy and Spain. Thus, the markets may well extend their rally in the near to medium term and we could see a move towards 1.2650 first then potentially to 1.2750. But the prospect of a rate cut by the ECB next week could limit the euro's gains. Also, the rally could fade if the markets feel like to make a real difference the EFSF/ ESM need more money.
In the short-term, the downside could be limited at 1.2575 (the Tenkan line on the cloud) and the upside could be capped at 1.2680. Above this level 1.2790 is a major target as it is the bottom of the Ichimoku cloud, and the end of the technical downtrend.
EURUSD daily chart
We think that stocks could be a larger beneficiary of the EU summit news today. The Eurostoxx index has been weighed down by its banking sector for months, so these developments could be positive for the European index. A break above 2,175 opens the way to 2,205 - the base of the Ichimoku cloud. This is the end of the technical downtrend, and we could see gains extended from here if the EU summit cheer lasts and if expectations build that the ECB could cut rates next week.
Eurostoxx 50: daily chart
Kathleen Brooks| Research Director UK EMEA | FOREX.com
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