FOREX: Euro May Fall Even if EU Delivers on Debt Crisis Measures

Talking Points

• Any Relief to EU Debt Crisis After Leaders’ Summit Inherently Temporary
• Euro May Fall Despite Success in Brussels as Fundamentals Return to Focus
• Australian Dollar Falls as Inflation Cools, Reinforcing RBA Rate Cut Bets
• NZ Dollar Sold Ahead of RBNZ Meeting as Business Confidence Disappoints

After weeks of speculation, the culmination of the latest effort to remedy the EU debt crisis is finally just around the corner as policymakers prepare to convene in Brussels for a final push to forge a lasting solution. Officials seemed to get off to a rocky start over the weekend, producing a list of what the EU won’t do to solve the crisis rather than what it will.

Broadly speaking, policymakers have to achieve on three fronts. They must: dramatically reduce the Greek debt burden by cajoling banks to “voluntarily” accept losses on as much as 60 percent of their bond holdings;come up with the money to recapitalize those banks, cutting off contagion from Greece into the rest of the EU and preventing an evaporation of liquidity that saps the already fragile economy of the credit needed to do business;and craft a mechanism for debt-strapped countries to secure funding, thereby avoiding a replay of the Greek drama elsewhere.

A flurry of proposals has emerged over recent days, with a dedicated swarm of pundits and prognosticators dissecting every imaginable aspect of the opaque tidbits released by anonymous “people familiar with the proceedings” to the newswires. Looking past the minutiae however, it is clear that the goal of whatever emerges after all is said and done will be – once again – to only temporarily placate the financial markets.

Indeed, the debt crisis was not born of the spending habits of Greece, Italy and company but of the inherent problem in lumping very different economies under one monetary umbrella while maintaining independent and widely divergent fiscal policies. This means that crafting a lasting solution will require cumbersome steps including augmenting the EU’s core treaties, a process that is surely not going to be complete over a weekend. This means the object of the game right now is to squash fears of an immediate meltdown, buying time to haggle over the long-term solution in the years ahead, and whatever plan is unveiled will be judged its merits to achieve just that.

Importantly, the Euro may find itself on the defensive even if the EU finally satiates investors with a set of clear, actionable steps to stop the near-term bleeding. Indeed, the single currency has rallied sharply since the beginning of October, adding over 5.5 percent against the US Dollar amid speculation that market turmoil was finally prodding lawmakers in the right direction. It is then not unreasonable to suspect that whatever “solution” is to be unveiled over the coming 24 hours has been priced in already, allowing the spotlight to shift back to the ominous Euro Zone fundamentals.

On that front, the currency bloc is expected to underperform most of the G10 at least through 2013 (with the exception of Japan, the UK and Denmark, and only in 2011). This is likely to feed expectations for interest rate cuts that already call for at least one reduction coming as soon as November-December, weighing on the single currency anew.

Related: Australian Dollar Plunges on Softer CPI Data; New Zealand Dollar Drops after Business Confidence Report

Asia Session: What Happened

Euro Session: What to Expect

Critical Levels

--- Written by Ilya Spivak, Currency Strategist for Dailyfx.com

To contact Ilya, e-mail ispivak@dailyfx.com. Follow me on Twitter at @IlyaSpivak

To be added to Ilya's e-mail distribution list, send a note with subject line "Distribution List" to ispivak@dailyfx.com