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EU Summit Scenarios and Impact on EUR

Last updated 10/21/2011 10:20 AM ET (GMT -5) 3 Comments

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Kathy Lien

Director of Currency Research, GFT

For the past two weeks, the euro has traded almost exclusively on the hope that Euro area policymakers will deliver a package of measures to stabilize the region and remove the risk of contagion.   This is no small task but if policymakers fail to deliver, all of the gains that the EUR/USD has made since the beginning of the month will disappear quickly.   This morning we learned that the EU has decided to hold 2 Summits over the next 6 days with a final announcement scheduled for Wednesday.   Expanding the meeting from 2 days reflects their commitment to delivering a comprehensive plan on Sunday and Wednesday and shows that there is some merit to the recent plans reported in the media. At this point, most traders expect the EU Summit to result in a dollar amount for bank recapitalization, a haircut for Greece and a decision on EFSF expansion. If the EU delivers, the euro could enjoy a nice relief rally that takes it above 1.40 but only if the amount of bank recapitalization and haircuts are satisfactory.   If for whatever reason European officials decide to postpone the announcement for the November G20 Leaders Summit (which is extremely unlikely) and ends up providing guidelines over concrete numbers, the euro will make a run for 1.35 as investors continue to wonder whether Euro area policymakers have what it takes to end the European Sovereign Crisis.  

Here’s the schedule for the EU Summits:

Friday – Eurogroup Meeting 

Saturday – German Chancellor Merkel and French President Sarkozy meet 

Sunday – EU Summit in AM, Eurozone Summit in PM, Press Conference to Follow 

Mon or Tues – German Government discusses Sunday Summit 

Wednesday – Second EU Summit to Ratify Conclusions

There are three pressing issues that the EU needs to address:

1)      What to Do with Greece

Given that the latest problems stem from the possibility of a Greek default, it is the number one priority for the EU.  Based upon their current fiscal finances, it will be impossible for Greece to meet their near and medium term financing obligations.  As a result, a haircut needs to be imposed on bond holders, which would reduce the amount of money that they would receive in return. Back in July, a haircut of 21 percent was agreed upon but according to EZ finance ministers Greek bondholders may have to settle for a cut between 50 and 60 percent.  A smaller haircut will be short term positive for banks but long term negative for risk because it would still leave Greece vulnerable to missing future debt payments. A deeper haircut on the other hand will mean greater upfront losses for banks which could hurt equities but will be a more sustainable solution to the sovereign debt crisis in the long run. If the troika decides to release the sixth tranche of aid to Greece, it would also lend support to the euro.  

2 )      How to Handle the Losses that Banks will Incur

Larger haircuts mean further losses for banks that are already suffering from unwillingness by investors to provide short term funding.  To boost investor confidence, the EU may force banks to increase their core capital ratio from 5 to 9 percent within the next six months.   Banks that are unable to reach the capital requirement could be forced to accept government capital, which effectively nationalizes the banks. In response, banks have announced plans to sell assets and reduce lending which would help cut their need for recapitalization.  Unfortunately that may not be enough to attract investors in the private sector.   A strong recapitalization plan is needed to stabilize investor confidence.  The number floated being floated around is approximately $100 billion. Anything short of that will be negative for the euro.  Banks will most likely be asked to find ways to recapitalize themselves through private capital first, which could be a challenge because private investments are hard to come by in this type of market environment. 

3)      How to Protect the Rest of the Region from Contagion

The third issue that the EU needs to address is how to protect the rest of the region from contagion.  One way would be to increase the size of the EFSF but given the amount of time it took to boost the fund to EUR400 billion, expanding it to 2 trillion euros would be an even greater challenge.   One way to skirt around the political, legal and financial difficulties of increasing the EFSF outright would be to lever the EFSF by guaranteeing initial losses up to 20 percent of the face value on the loans.  This is a plan that is supported by many in the region including the Germans. The larger the first loss insurance, the more positive it will be for the euro. The French want to give the EFSF a credit line from the ECB but opposition from the central bank and the German government makes the chance of this happening slim. After accounting for the current commitments, the EFSF only has about EUR 270 billion left for leverage, which is just enough to cover 20 percent of the gross funding needs for Italy, Spain and Belgium. 

Earlier this week, there were talks that Germany and France have agreed on a EUR2 trillion rescue fund for Europe that would involve both bank recapitalizations and levering up the EFSF.  Although German and French officials have denied that a EUR2 trillion bailout package is in the works, 2 trillion will be magic number for investors in the week to come.  If the eventual rescue is smaller than that amount, it could prove to be disappointing to investors.  If it meets or exceeds 2 trillion, expect the euro to trade sharply higher as short euro traders rush to cover their positions.  

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Comments (3)

mbrad77

October 21, 2011 at 11:21 AM ET

thanks for providing the calendar

Darkdoji

October 21, 2011 at 04:22 PM ET

Yea well thanks for everything - this is profound enlightenment and now that I know what it is all about this is what I think - Regardless of outcome the smart would start selling the Euro like crazy come next week - there is nothing here that has not been priced in already and given the macroeconomic disequilibrium local to the Euro and globe in general that is emergent and real (despite somewhat positive data from the USA of late), the market needs to start discounting for possible rate cut (in the Euro), economic contraction and rumors of contraction (risk as a group). This rally is crazy it needs to be over starting closing bell.

PS: This was the simplest and clearest (and therefore most useful) piece I ever read on the whole darned Euro crisis. Seriously I commend the write up and the author (and it was short - at least relatively). Thanks Ms. Lien.

Darkdoji

October 23, 2011 at 03:14 PM ET

Is the Euro @ 1.00000 yet? Should be on open. First they lied - no Greek default, not even partial. Now the talk is of 50 - 70% write downs, voluntary of course. Then just a 100b for bank recapitalization (not enough) and almost a year from now time frame being suggested, forget fiscal integration since relatively simpler issues are dragging out, then no real backstop (ring fence) - cos ECB will not be a lender of last resort and EFSF will not be organically bigger - the talk is of limited insurance (and for new debt only I hear) and so on and so forth. Of course there is now talk of QE3 and this time - the kites are flying high. Two top bobs in the fed scheme of things flying kites - so yes at some point there may be rebound - but with possible rate cut around the corner for the Euro and the regular "the world is going down jitters" plus a slack or postponed outcome Wednesday - should guarantee parity before we see sunshine - just my thoughts and hopes - even if parity sounds too severe. The thing is that these Euro politicians need to see a red card - ala soccer - I do not understand why it is taking the market so long to show em one.

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About The Author

Kathy Lien began her FX trading career 10 years ago at J.P. Morgan Chase. After graduating New York University’s Leonard Stern School of Business at the age of 18, Kathy joined the bank's interbank FX trading desk and eventually moved to the cross markets proprietary trading desk. In the interbank market, her ability to create solid fundamental and technical analysis from the myriad of information on the market helped her trade forex spot and options. Her experience eventually led her to be chief strategist at Daily FX where she worked until she joined GFT in 2008.

With her knowledge of forex, as well as her experience trading other products, such as interest rate derivates, bonds, equities, and futures, Lien has built a reputation as an international currency analyst. She is frequently quoted on CNBC, Bloomberg, Fox Business and Reuters. Lien has also written for publications like Active Trader, Futures, and SFO magazine. She is the author of the newly updated Day Trading the Currency Market: Technical and Fundamental Strategies to Profit from Market Moves, and the co-author of Millionaire Traders: How Everyday People Are Beating Wall Street at Its Own Game with Boris Schlossberg.

To buy Kathy’s newly updated Day Trading and Swing Trading the Currency Market: Technical and Fundamental Strategies to Profit from Market Moves, click here.