Europe Update

Word is still not official, but clearly European officials have taken another step up the escalation ladder to combat the sovereign debt crisis that is threatening to disrupt the recovery seen in the capital markets over the past year.

The latest is that as much as a 600 bln euro package is being put together. It appears that it may consist of around 440 bln euro of loan guarantees and another 60 bln euro stabilization fund. The IMF may provide another 100 bln euros.

As often, the devil is in details and the specifics are not clear yet. The market wasted no time though to reduce short euro positions. The extreme market positioning is not simply in the record short euro spec positions at the IMM (which is now more than twice the record short set in 2008), but also in the premium for euro puts over euro calls (3 month risk reversal closed a little above 3.25%), which is also a record.

The latest leg down in the euro began on May 1, and assuming this move is being corrected now, from a technical perspective, the 50% retracement near $1.2945 was tested initially in thin pre-Tokyo activity. The next objective is just above $1.3040.

The new measures from Europe will help initially and it would not be surprising if now that the governments are taking new measures to address solvency, that the ECB comes up with new liquidity measures. Recall before the weekend 3-month Euribor rose to 68.2 bp,the highest in several months and the overnight deposits at the ECB jumped to a 10-month high of 290 bln euros. The scramble for funding say TIBOR and LIBOR rise sharply too.

The key issue will become whether this new package is sufficient. It may be enough in the short-term. Between Greece, Portugal, Ireland and Spain there is almost 200 bln euros of debt maturing over the next three months. Although Italy has been spared most of the stress, that could change as it alone has 100 bln euros of debt that needs to be rolled over in the next three months. Nevertheless, because Europe has had to be pushed kicking and screaming each step along the way, the risk is that the solvency genie is out of the bottle and it may be difficult to put back in.

Many market participants remain concerned that some sort of debt restructuring maybe increasingly inevitable and past experience suggests the earlier it is acknowledged, the better for all the stakeholders. The euro has gapped sharpy higher and that downside gap may attract some backing and filling action. The bottom of that gap, last Friday's high, is found near $1.2798. A break of this level is a sign that plan may not be sufficient to turn market sentiment.

In the larger picture, I think that even if Europe's plan works, the euro will continue to trend lower (after the correction) as the fiscal austerity will make for slower growth, which in turns will mean that it will take longer to close the output gap. Meanwhile, the US jobs data should underpin the upcoming series of economic reports.