Highlights

  • 'Do or die' for Eurozone debt crisis
  • Risk rebound continues

'Do or die' for Eurozone debt crisis G-20 finance ministers are meeting this weekend to lay the groundwork for the Nov. 3 summit in Cannes, while European leaders continue negotiations ahead of their pivotal summit on Oct 23. We don't expect too much to come from this weekend's G-20 in terms of initiatives, but we think the group is likely to reinforce the global pressure on the Europeans to deliver on promises of a comprehensive solution to the debt crisis. Markets have given EU leaders the benefit of the doubt, but they still need to come up with a credible program as the environment is ripe for disappointment. The key issue they need to resolve is the effective lending capacity of the EFSF to halt contagion in debt markets to Spain and Italy, and potentially other large economies. The latest comments from ECB leaders suggest the central bank will not allow itself to be used to provide lending leverage to the EFSF, leaving it up to the national governments to devise a solution. Word so far is that discussions center on the EFSF insuring 20% of bond issues from troubled Eurozone governments. Such a plan would allow the EFSF a total capacity of around EUR 1.25 trillion, better than the remaining EUR250 bio of unallotted funds in the EUR440 bio EFSF, but still below the magical EUR2 trillion markets would like to see. An increase of that size may also be deemed insufficient as it would then not have enough to fund troubled Eurozone banks' recapitalization efforts. As such, we are not sure how such a plan would be received by markets, but tend to think 'underwhelming' may be the response. There are many other issues left to be resolved: how EU banks will go about recapitalizations and how much they'll be required to raise; how much of a write-down on Greek debt will bondholders be forced to 'voluntarily' accept (and will that be deemed a 'credit event,' triggering payouts on CDS); will other troubled countries be allowed to restructure their debts; to name just a few. We think there is great potential for disappointment, but we'll have to wait until the Oct. 23 meeting to see what the EU comes up with. A frequent comment of late is that It had better be good, or else.

Risk rebound continues Risk markets have continued to recover higher and are finishing out the past week on their highs, with no sign of a top yet in sight. Excessive short-risk positioning has been among the key drivers, but better than expected recent US data has also helped support risk appetite. The view seems to be that as long as the US avoids a double-dip recession, fears of a global recession will fade. But we would also note further ominous forward looking developments that suggest the current risk rebound will likely fail soon. Chinese Sept. trade data showed a larger than expected drop in exports, owing principally to a drop in exports to Europe, which we take as a further sign of the deteriorating outlook on the continent. Also, Germany's leading economic institutes slashed their 2012 GDP forecast for Germany from 2.0% to 0.8%. While the relief rally on the EU debt crisis plays out, we think it's important to keep in mind that growth is stagnating there, which will ultimately aggravate efforts to solve the long-term debt solution. Without sufficient growth, high debt burdens will continue to plague European nations in the years ahead. For the time being, however, further gains in risk assets seem most likely, with EUR/USD set to finish the week above key 1.3830/40 resistance, setting sights on 1.4040/50, with the September highs at 1.3930/40 as intervening resistance. US Stocks are closing the week just below the key 1220/30 level in the S&P 500, where a break above would suggest a fresh leg higher. AUD/USD, arguably the leader in the risk-FX bounce, is just below a multi-month declining channel top at 1.0355/65, where a break above may signal a further rally Gold prices are also just below the key 1690/1700 area, which we think is a gateway to further gains. In the JPY crosses, EUR/JPY has also reached a critical resistance zone in the 107.50/108.00 area, where a move above may signal further gains ahead. The extent of the rebound in risk has surprised us given the overwhelmingly dark clouds on the horizon. But a credible solution to the Eurozone debt crisis may provide further upside to risk, as the whole world is leaning on the Europeans to deliver. Still, we will be alert for any signs of a potential top forming, such as sharp intraday reversals, to look for opportunities to re-short risk assets. Overall, next week could see some consolidation develop in light of overbought short-term conditions and ahead of the EU summit, now that so much optimism has been priced in on so little of substance. Expect headlines and data to continue to drive short-term price moves.

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