Previewing the European Summit June 28-29
The European Council is set to begin its summit this Thursday, June 28, with much to contemplate and discuss. With the recent escalation of the European Debt Crisis, the question of the future of the euro as a currency union continues to dominate the market.
Talk of a Greek exit from the currency union was prevalent leading up to the Greek elections, but those fears have been quelled at least for the near term.
Traders may wish to hold back their excitement on this summit, as time and again, European leaders have over-promised and under-delivered. First, was the promise of the expansionary fiscal contraction, the policy otherwise known as austerity that was thought to magically boost growth. However, the only result was that twelve of the seventeen euro nations have slipped back into recession.
Next, it was promised that bailout funds would be levered and allowed to buy up sovereign bonds. Once again, these hopes went unfounded.
For this current meeting, leaders will discuss economic policy, mainly stimulating growth and fighting the pan-European recessions. European leaders will be discussing ways that they can, both at the national and the pan-European level, stimulate growth and job creation, especially for the young.
Second, leaders will discuss how to implement a European financial framework. Speculation is that this will include the discussion of deposit insurance and a European banking regulator, however these hopes may go unfounded. Lastly, members will debate foreign policy issues, however these will be less important in investors' minds.
Traders should expect lots of grandstanding, lots of promises to stimulate growth, and lots of reluctance on the part of the German contingent to commit further resources to bailouts. Today, both William Buiter of Citi and famed investor George Soros have suggested some form of a debt modification institution, aimed at purchasing the bonds of sovereign nations outright.
As Soros writes in the FT, "It would finance the purchases by issuing European Treasury Bills – a joint and several obligation of the member countries – and pass on the benefit of cheap financing to the countries concerned. The Bills will be assigned zero risk rating by the authorities and will be treated as the highest quality collateral for repo operations at the ECB. The banking system has an urgent need for risk-free liquid assets. Banks are currently holding more than €700bn of surplus liquidity at the ECB earning only one quarter of 1 per cent interest. This assures a large and ready market for the Bills at 1 per cent or less."
Both gentlemen are calling for further fiscal consolidation of Europe. The events over the last few years have seemed to indicate that a monetary union lacking a fiscal component has led to a further divergence in competitiveness and wages, not a convergence, as many had predicted at the onset of the euro. It was believed that Germany and other strong nations would pull less competitive nations up, making them more competitive and align the economies of Europe. Instead, Germany saw its currency artificially suppressed while the fiscally profligate nations received access to cheap funding.
The real dilemma for Europe is one of how to create a fiscal union, with budgetary and all other domestic monetary sovereignty turned over to a central European authority.
Analysts from multiple institutions have stated that just the blueprint of a fiscal union, if it were laid out today, would be enough for the market. If the blueprint of a fiscal union involving debt mutualization through a new institution and the introduction of Eurobills and eventually Eurobonds were to come to light, this would be a market positive, for two reasons.
First, it would be a large step for Germany, effectively taking the responsibility for the fiscal prudence of the peripheral nations. However, more importantly, it may allow the European Central Bank (ECB) to act. Speculation is that President Mario Draghi has been waiting for European politicians to act before the monetary authority launches a new round of easing, either through a rate cut or another round of liquidity operations. Analysts at Credit Suisse agree, saying that "the political priority is progress towards a banking union, but a (very) gradual move towards limited debt mutualization, accompanied by more aggressive ECB action, seems inevitable; the obvious risk being that European policy will only respond to yet deeper market dislocation." Thus, politics may be getting in the way of the grand solution.
In terms of market implications, the summit may not have a real effect. It will take a truly unexpected result, along the lines of a banking union or commitment to imminent debt mutualization, to move financial markets. Headlines will surely be aplenty, as each leader will have his/her time to speak to the media after the meetings conclude. One thing to watch will be the relationship between the new, pro-growth leaders of France and Greece and German leaders who largely push austerity.
A smart trade may be a double-no-touch (DNT) forex options strategy on the EUR/USD or even the EUR/JPY, for they have traded in ranges and this strategy allows investors to profit from range trading. In EUR/USD, the currency pair has been locked in a 1.23/1.2765 range over the last few weeks, trading lower on negative sentiment and higher on positive. As the news headlines move sentiment, trading this range through a DNT strategy with expirations in a few months may be logical.
For less sophisticated traders, simply trading the EUR/USD at spot or the euro through an ETF such as the Currencyshares Euro Trust (NYSE: FXE) allows traders to have exposure to these shifts in sentiment. For equity only traders, consider taking a long-short position, being long U.S. equities through an index ETF such as the SPDR S&P 500 ETF (NYSE: SPY) and being short euro stocks through the iShares MSCI EMU Index (NYSE: EZU). Such a strategy would profit from the outperformance of U.S. equites vs. EMU equities, if investors believe that to be the case.
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