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So far it’s been a fairly strong week for markets, with the considerable expectation weighing heavy ahead of Friday’s EU summit.   Stocks are pushing levels last seen early November, whilst emerging and high-beta currencies (principally the Aussie) have pushed ahead against the dollar by an average of 1%.   The single currency is also performing relatively well.  

Part of this is down to the significant volume of short positions in the market, making it painful for investors to continue to be bearish into the end of the week. However, scratching beneath the surface of Monday’s Merkel/Sarkozy get-together is not that positive in terms of faith that the leaders are pushing ahead along the correct path.

The proposals announced reflected an inability to understand the causes of the crisis, but also failed to go as far as outlining the path towards a fiscal union, in part let alone in full.   Markets appear to be trading more off the implications and hopes for a more aggressive stance from the ECB; they have placed a great deal of hope in the outcome of the next few days.

Guest post by FxPro

Commentary

The continuing danger for euro bears.  Although perfectly understandable, the danger for the growing sleuth of euro bears remains that they become slothful about being short. Over recent weeks, there has been growing evidence that investors and traders alike have been seeking to move money out of the single currency. Sovereign wealth funds, which earlier in the year were committed buyers on weakness, are now seen less frequently. Real-money managers have similarly been reducing their exposure to the euro in favour of currencies such as the dollar and the Japanese yen. High-net worth investors in Europe have been actively diverting some of their wealth out of the euro and into the likes of high-end London property, dollar deposits, and gold.   Traders are also collectively convinced that the euro is headed much lower. According to the latest figures from the CFTC, euro short positions held by large speculators soared to over 100K in the week ending November 29th, very close to the record short positions taken out 18 months ago during the last eurozone crisis. In May and the first half of June 2010, large speculator shorts in the euro were around or above 100K. Over that time period, the euro fell from around 1.33 to just below 1.20 by early June before surging to above 1.40 by early October. On that occasion the intensity of the short squeeze really hurt many traders who were slow to cover.   A similar danger is emerging. A further increase in short positions by traders cannot be ruled out in the near term, at a time when high net-worth and institutional investors still seem minded to reduce their exposure to the single currency. However, the bearish consensus is very extreme. It could very well be that rather too many are convinced that the euro has a lot more downside.

The SNB must be brave again.   September’s audacious move by the SNB to impose a ceiling of 1.20 on EUR/CHF needs to be repeated when it meets next week to review monetary policy. This yesterday’s CPI data will only reinforce the concerns that a number of SNB officials have expressed recently; consumer prices fell 0.5% YoY last month and the economy appears to be lurching back into recession, dragged down by a still overvalued exchange rate and Europe’s economic disintegration. With interest rates already essentially at zero, the SNB must be considering a further increase in the ceiling. According to some estimates purchasing power-parity suggests the CHF ought to be nearer 1.50 than 1.24. It would be very surprising if the SNB responded to this very threatening set of economic and financial challenges with only a small increase in the ceiling. Our sense is that the ceiling will be raised to at least 1.30 when the SNB meets next week.

The holes in the Merkozy message.  There are three gaping gaps in the Merkozy message of earlier this week.   Firstly, the mention of 3% limit for government deficits, with subsequent automatic sanctions.   It’s an arbitrary number that takes no account of debt sustainability or the current account imbalance which has an impact on whether debt has to be externally financed or not. Second, the enforcement and surveillance mechanism remains weak.   This was a key flaw of the previous regime.   Between 1990 and 2007, of the founding nations of the euro, SGP deficit levels were breached 19% of the time and debt 42% of the time.   Only half met the debt criteria in the first year of the single currency. Yes, dispensations were granted but then rules were softened, initially by France and Germany.   Finally, it’s not fiscal union. Ok, maybe it’s not meant to be, but that being the case it is the weak sibling thereof.   Perhaps putting true fiscal union in place at this stage is seen as a step too far (as is the case with ‘eurobonds’ or ‘common bonds’), but a system of central surveillance, with a sub-optimal sanctions regime wrapped around a discredited deficit benchmark, is not the right step towards having some degree of fiscal harmonisation eventually. When push comes to shove, national political agendas and needs will dominate those of the EU leadership or its budgetary edicts.   And are fines really going to work?   After a period during which the few (Greece, Ireland, Portugal) have wielded such power and influence over the majority, it’s difficult to envisage or believe that they will.   Fiscal union requires a degree of centralised taxation, spending and political decision-making; that’s the bottom line. Sarkozy and Merkel’s proposal falls short of this, which sets it up for failure