By Market Strategy Team

Markets have traded with a generally bullish tone over the past week, although they have not added much to the gains observed earlier in October. Many risk assets are trading at or near the tops of the ranges that have prevailed since early August, although signs of significant stress remain evident in certain areas, especially money markets and peripheral European government bonds.

While a somewhat improved trend in the economic data flow accounts for much of the recent optimism, markets also appear to be adopting a more hopeful attitude about euro area governments’ efforts to cope with the ongoing crisis there. On this front, although European policymakers appear to be coalescing around a plan to address several near-term problems, plenty of room for disappointment remains. Indeed, after initially scheduling and publicizing a high-profile leaders’ summit for this past Sunday, eurozone leaders at the end of the week abruptly changed the date for substantive announcements to Wednesday, October 26. The delay probably stems in part from local political requirements, in particular Chancellor Merkel’s need to clear significant initiatives with the Bundestag. At the same time, the postponement probably also underscores the ongoing lack of consensus about significant aspects of the eurozone plan. Having heard grand plans several times already, markets will likely sell off if this Wednesday’s announcements are long on ambitious concepts and short on details.

Judging from press reports, eurozone leaders are seeking to advance in three areas:

1. Greece. With the Greek government falling behind the fiscal targets agreed on earlier this year, and with a larger financing gap thus opening up, its eurozone official creditors need to renegotiate the bailout program. While they are likely to kick in a bit more cash themselves, they will also seek to increase the burden on Greece’s private-sector creditors, who had previously offered a reduction in their claims on the order of 21%. Markets will watch the size of the private-sector write-downs to be announced: the larger the write-downs, the better, from the perspective of Greek debt sustainability. But markets may react negatively if there is a perceived hit to bank capital and if the arrangement is viewed as being coercive. The point about coercion matters in the context of the possible triggering of Greek credit default swaps (CDS) contracts.
2. Banks. Markets have worried about European bank solvency for some time and the possibility of significant write-downs in banks’ government bond holdings. The strains associated with what looks likely to be a new downturn in regional economic activity have significantly increased this concern. In response, eurozone leaders intend to conduct another stress test on systemically important banks, after which banks will be required to raise capital to meet new, higher standards. Here, markets will weigh the credibility of the stress test (with recent reports suggesting a reasonably rigorous calculation of the sovereign debt issue but possibly the avoidance of consideration of the coming recession); the size of the reported target for increased capital; and the process through which capital will be raised. A credible stress test that clearly identifies each bank’s need, especially if the resulting numbers are lower than some recent analysts’ calculations, would likely help restore confidence in the system. Easing pressure on bank short-term funding could serve as an offset to what might be a lengthy deleveraging process as institutions seek to meet higher capital requirements.
3. European Financial Stability Facility (EFSF) operations. The beefed-up EFSF, with its larger size and expanded operational capability, received its final approval from euro area parliaments recently. Now, policymakers need to spell out exactly how it will approach its main task at the moment: protecting Spain and Italy from fallout resulting from a possible Greek default. Even the increased EFSF does not have enough resources to relieve these two large countries from the need to fund themselves in the market over the next few years. In the past week, authorities have focused on a plan to provide partial insurance for new-issue Spanish and Italian bonds, covering 20-30% of eventual losses and thus expanding the notional size of the protection available (though not, of course, changing the true monetary amount of the subsidy to bondholders). But this approach could prove tricky to implement, and its attractiveness to bond buyers is uncertain. Policymakers seem to be casting around for alternatives.

The greatest uncertainty surrounds the EFSF. On Greece and the banks, specific numbers remain open to question. But on the EFSF, even the big-picture plan has yet to come together completely. If it does not appear to be doing so by Wednesday, markets will worry about the safety net underneath Spain and Italy and their bond spreads, which remain near recent highs, will likely widen further.

Meanwhile, the economic data continue to support a more optimistic view of U.S. growth – at least relative to beaten-down expectations. GDP data for the third quarter, to be published Thursday, will likely print at 2.5% quarter-on-quarter (Q/Q), seasonally adjusted annual rate (SAAR), the strongest figure this year, benefiting from the resumption of Japan-related activity. Higher frequency data, such as jobless claims, suggest that growth began the fourth quarter at a broadly similar pace of around 2%. The market’s concern about the possibility of a near-term recession appears to have faded. Still, 2% growth will not suffice to bring down the unemployment rate rapidly, and storm clouds loom on the horizon, in the form of the likely euro area recession and U.S. fiscal tightening into 2012. This uncertainty, along with the ongoing euro area saga, will likely serve to keep risk markets within, though possibly still at the top of, their recent range.