Reaching the Summit, Facing the Cliff Edge

Reaching the Summit, Facing the Cliff Edge

• Rebound in risk sentiment underpinned by hopes for the coming week’s EU summit
• EU leaders’s appear to be converging and entrenched positions softening, but risks are high.
• Modest 0.25% ECB rate cut expected, Bank of England to hold off more QE until January.

Risk sentiment improved sharply this week with Euro area stock markets posting gains of 10%+. The turnaround in sentiment appears to have been motivated by hopes of a resolution to the Euro area crisis. But the liquidity support operation announced by the major central banks clearly helped, as did the easing in monetary policy in China and Brazil. Against this background, hopes are riding high that the coming week’s key EU Summit will deliver a lasting solution to the Euro crisis - arguably it could be the last real opportunity for doing so. We are cautiously optimistic that they will deliver.

While cynically, we may feel we have been here before, there do appear some key differences this time. Merkel, Sarkozy and Monti’s recent meeting suggested some convergence over the views on longer-term changes to Euro area governance and treaty change. Monday’s Merkel and Sarkozy meeting will be important. With this in play, a number of other entrenched positions appear to have eased: Merkel on IMF funding, ECB President Draghi suggesting the  CB could increase its response and Sarkozy increasingly accepting budget co-ordination. Hope is building that a longer-term road map for reform could be laid out and that this would smooth the way to address the symptoms of high bond yields, perhaps via the ECB. Markets are balancing hope and experience ahead of the Summit, but a failure on Friday could trigger a wave of disappointment. Before the Summit the ECB holds its monthly meeting. While we see a pivotal role for the ECB in crisis resolution, both in terms of stimulating growth through monetary policy and accessing its balance sheet, Draghi has stressed the “sequencing” of events is key. We do not expect sweeping  nnouncements ahead of the Summit.

However, the ECB publishes its medium-term forecasts this month and is likely to mark down growth and inflation projections from September. This should persuade the Council to cut the refi rate by 0.25% for the second successive  month to 1.0%. As interesting will be discussions of 2 or 3 year LTROs, which we view as tantamount to QE. We envisage the ECB introducing these only after Summit agreement. After Governor King’s dire warnings over the risks the Euro area poses to the UK, one might expect. 

December’s MPC meeting to boost QE further, but we expect the MPC to leave policy unchanged. This is not because it does not see downside risks, but rather that it believes the current pace of cash injection is close to “market  apacity”. We expect the MPC to sanction more QE, but expect this to start with £50bn in January,closer to the expiry of the current £75bn and with greater clarity on Euro area developments. With markets focused on policy  easures, Economic releases are likely to take something of a backseat. China’s November releases look set to show a further slowing in activity, but an easing in price pressures. This is likely to see the Peoples’ Bank of China continue with Reserve Ratio cuts in 2012. The US calendar is light. However, decent ‘core’ retail activity should be consistent with an upbeat non-manufacturing ISM index and we will watch for the downward trend in jobless claims to  e maintained. The US is showing increasing signs of recovery, but it and wider market resilience will depend on renewed progress towards a Euro area solution. 

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