Merkel's No Tax Cut Warning is Euro Negative

The market has scrambled to adjust positions in the wake of the new European initiative. German Chancellor Merkel, who lost control of the upper house of parliament yesterday, has told reporters that there cannot be new tax cuts for at least two years. This is unfortunate. It means that the underlying imbalances in Europe will not be addressed. It means that the fiscal tightening that is going to take place in Greece, Portugal, Spain and Ireland is not going to be offset by some easing of policy by Germany.

Most of the euro's gains were registered before Europe opened and since a little after 8 gmt (4 am est) just below $1.3100, the euro has pulled back a little more than 1% to find support near $1.2940 (trend line on hourly charts and near a retracement target) This may prove to be a swing area, determining its near-term fate.

On one hand, significant measures have been taken to stabilize the market. We have understood the market's bearishness toward the euro partly a reflection of European officials inability to get ahead of the curve of expectations. The new measures overcome this objection.

On the other hand, the significant measures have a heavy price. The ECB purchases of sovereign bonds in the secondary market, even if sterilized, poses a risk to its credibility. Its balance sheet will deteriorate as you can bet your last euro than the bonds that are bought will not be German bunds.

Since the operation will be sterilized by the ECB, few will see it as a form of quantitative easing, but if it is not QE than it is a type of direct fiscal support. It is true that ECB will not and cannot purchase the bonds in directly from the sovereigns, but so it does so indirectly.

Does the ECB's purchase of sovereign bonds make a debt restructuring more or less likely? Of course, the immediately reaction is that it makes it less likely.

But upon closer reflection, maybe taking the bonds off the private sector's hands, and the data suggests that more than 70% of both Greek and Portuguese debt are not held domestically, would help facilitate a more orderly and "friendly" restructuring?