ECONOMETER

As last week progressed markets had been increasingly poised for disappointment at the EU Summit at the end of the week. Given such low expectations it was probably not so difficult to exceed them. In the event there was progress towards breaking the vicious cycle between banks and sovereigns. The immediate reaction to the announcements from the EU President was clearly positive, with risk assets rallying sharply. EUR/USD had rallied by over 2 big figures from a low just above 1.24 as a massive short squeeze helped propel it higher.

With their backs against the wall EU leaders finally agreed upon short term stabilisation measures as well as long term measures towards closer European integration. Under pressure from other leaders including French President Hollande, German leader Merkel obviously softened her stance to agree on some of these measures. The deal goes to show that leaders in Europe can act when needed or at least when desperate which is how they were after 13 hours of talks and the reality that bond yields in Spain and Portugal were at unsustainable levels.

Short term measures in particular utilising the EFSF / ESM bailout fund to recapitalize banks directly and the creation of a European banking supervisory body was a shot in the arm for Italian and Spanish bonds and the EUR. The dropping of the condition that EU governments be given preferred creditor status for loans to Spanish banks bodes well for peripheral Eurozone sovereign debt markets as it means that private investors will not be put at the back of the que in any debt restructuring.

While the measures mark an important step in the direction of providing clear resolutions to the Eurozone crisis there is a very long way to go. Admitedly the use of the bailout funds is positive but at some point markets will ponder the fact that while they could handle a bailout of Spain the funds are clearly insufficient to cope with a bailout of Italy should it be needed. If the steps announced at the EU summit lead to a sustained drop in peripheral country bond yields then the prospects of more bailouts will be limited but this is by no means guaranteed.

Whether the risk rally is sustained into next week depends in part on whether the European Central Bank responds with actions of its own by cutting interest rates or by indicating the use of other measures such as restarting its securities markets purchases program. The risk remains that the rally will likely fade as skepticism sets in again once again and more details are sought.