1.Another “Make or Break”  EU Summit – Treaty Changes Focus of Dec. 8th-9th Summit

The December 8th-9th summit is shaping up to be another of those EU Summits in which a final plan or resolution to the sovereign debt crisis is presented.

The broad outlines of a deal are becoming apparent as we have major players including Angela Merkel, Nicolas Sarkozy, Mario Monti, Mario Draghi and Herman Van Rumpoy articulating the same points of late.

The main theme pushed by Germany has been to create tighter fiscal integration of euro zone countries – including peer review budget deficits, automatic debt breaks and sanctions for countries that don’t follow fiscal rules. This would enshrine a blueprint for “fiscal union” that would give stability to the Euro-zone over the long term. Until this step is accomplished it will be nigh impossible to convince Germany to increase its contribution to bailout funds or let the ECB step up its role in the crisis (play the role of lender of last resort).

Once these treaty changes are in place, the focus turns to reforms of national governments including Italy’s plans for austerity. The package that Mario Monti is presenting, scheduled for December 5th, should try and win back some confidence of bond markets. With Monti at the helm will Italy – with 2-year and 10-year yields near 7% – will push through tough reforms and create credibility among bnod market participants.

From Financial Times: “The government made no official statement, but according to those briefed the package is aimed at consolidating €24bn – more than expected – through tax increases and spending cuts in order to meet the target of balancing the state budget by 2013.

The reported measures include raising the age of retirement, a freeze on pensions next year except for low earners, increased income tax for high earners, €2.5bn in cuts on health spending, and the imposition of a property tax.

Labour market reforms aimed at boosting Italy’s stagnant economy are expected to be proposed in separate legislation after the fiscal measures are in place.”

With these two central planks in place – changes to enshrine closer fiscal integration as well as renewed vigor in wayward countries cutting their debt loads – then the ECB may be more willing to step up its role in fighting the crisis – including helping to build a firewall that is strong enough to stop the spread of contagion.

But to start this sequence of events the first step is for Germany, France and other Euro-zone and European Union nations to agree to what amounts to treaty changes to EU documents at this week’s EU Summit.

For this week, here’s what needs to happen:

1. France and Germany will give their proposals at the beginning of this week.
2. We await the announcement of austerity measures from the Italian government.
3. We see if treaty changes will in fact be enshrined during the December 9th EU Summit.
4. If euro-zone countries can come to some firm agreement towards fiscal union, then we’ll see what type of stepped-up role the ECB is willing to take.

2. ECB Rate Decision – Another Rate Cut At Hand

The EU Summit will come amid the ECB meeting in which expectations are rising that the Governing Council will cut interest rates by another 25 basis points to 1% from 1.25%.

The recent macro data has shown the euro-zone sliding into a mild recession and with rising concern about a credit crunch, the outlook for the Euro-zone shows significant downside risks.

Jürgen Stark that chief economist on the governing Council has said that inflation is set to decline below 2% next year and that that there is increased uncertainty and higher prospects for recession.

From Nasdaq: “European Central Bank Executive Board member Juergen Stark struck a relatively dovish tone Friday ahead of next week’s rate decision, saying that inflation in the euro zone will slow next year below the central bank’s medium-term inflation target and that an outlook for a deteriorating economy and continued high uncertainty were behind last month’s surprise interest rate cut.

The ECB projects that euro-zone inflation will fall below 2%, its medium-term target, in the course of next year as the economic outlook has worsened and ” it’s reasonable to expect moderate price, cost and wage pressure” amid the ” intensified downside risks,” Stark said.

That assessment led the ECB to cut its policy rate in November to 1.25% from 1.50%. The ECB’s Governing Council will meet next week again to decide about rates. Analysts polled by Dow Jones Newswires expect the ECB to shave its policy rate further in December, to 1.00%.”

The Governing Council already fired its first show at new ECB President Draghi’s first meeting by lowering rates in November. With funding pressure at the core of recent European bank woes, and the coordinated action by central banks last week to help ease funding pressures, a move by the ECB to lower rates would be helpful.

This comes despite inflation currently running at a pesky and high 3%.

We should therefore look at the ramifications both in the short-term and long-term of the Euro narrowing its interest-rate advantage against currencies like the US dollar (near zero), the yen (near zero), pound (0.50%), Canadian dollar (at 1% would be equal to ECB – an interesting development for the EUR/CAD), and the widening of the interest-rate advantage versus higher yielding currencies like the Australian (4.25%) and New Zealand dollar (2.50%).

3. RBA Rate Decision – RBA to Cut Interest Rates As Well to 4.25%

Speaking of interest rates and the Australian dollar, we are expected to see the Reserve Bank of Australia cut interest rates this week at their interest rate decision – scheduled for Tuesday evening for those in the US, or on Wendesday morning for those in Australia.

The RBA lower rates from 4.75% down to 4.5% earlier in November, the first time it has reduced interest rates since following the 2008 crisis.

Looking at overnight index swaps, which gives us a reading off banks expectations for what the central bank will do 1 year from now, we see a move in favor of more interest-rate cuts by the RBA.

While the mining sector continues to produce robust growth for Australia, the rest of the economy has seen a much rougher 2011, and with 175 basis points of rate cuts price in by money markets, we expect part of that will come this week as the RBA cuts rates to 4.25%.

The reaction we’ve seen by central banks around the globe last week – China reducing its reserve ratio requirement, Brazil lowering its interest rates, the coordinated action by the Fed and other central banks on dollar swaps – all point to more aggressive steps to help ease monetary conditions, as well as concern about the fall-out from the Euro-zone crisis. We expect the RBA to follow in the rest of the central bank’s footsteps and stay on the side of caution by lowering rates.

This means that the Australian dollar (AUD) further narrows its interest-rate advantage against other key majors as it currently has the highest interest rate among the majors. Relatively speaking it will continue to hold that advantage, but  nevertheless that advantage is set to narrow as we move through 2012.

If the RBA holds this week and paints a more hawkish picture, then the AUD could be set to rally from such news, especially if it comes amid general risk-on sentiment during the week.

4. BOC, RBNZ Rate Decisions Not as Exciting, But Still Important for CAD, NZD

While not as exciting as the ECB and RBA decisions we do also have the Bank of Canada (BOC) and the Reserve Bank of New Zealand (RBNZ) on tap this week. They are both expected to hold rates steady at 1% and 2.5%, respectively.

In their previous interest rate decision the BOC played up the downward risks to inflation which means that they are in no hurry to raise interest rates.

“As a result, core inflation is expected to be slightly softer than previously expected, declining through 2012 before returning to 2 percent by the end of 2013. The projection for total CPI inflation has also been revised down, reflecting the recent reversal of earlier sharp increases in world energy prices as well as modestly weaker core inflation.  Total CPI inflation is expected to trough around 1 per cent by the middle of 2012 before rising with core inflation to the two per cent target by the end of 2013, as excess supply in the economy is slowly absorbed.”

We’ll see the latest assessment from the BOC, but at this point they look like they are content to be in a “wait-and-see” mode.

The New Zealand Dollar (NZD) had a very strong week last week, but it comes amid general weakness for the Kiwi during the last 4 months (screenshot from Chart.ly). A dovish RBNZ could unwind the gains in the NZD from last week, especially if joined with a general move towards safety and away from higher yielding currencies.

In their RBNZ Financial Stability Report, the central bank struck a dovish tone, which had weighed on the Kiwi prior to last week’s rally.

From the National Business Review: “The decision was announced this morning in the central bank’s latest biannual Financial Stability Report – a report which says risks have increased since the last one (in May) and that New Zealand banks will face higher funding costs (and will have to push up interest rates) if the situation continues to deteriorate.

The risk of a “sharp deterioration” in the New Zealand currency also appears to have increased, the report says. ”Sharp depreciation would likely occur if global conditions deteriorate and investors seek to reduce exposure to risky positions such as carry traders in the NZ dollar.”"

Overnight index swap markets show that 1-year out, the RBNZ is expected hold rates around at around their current levels. Throughout most of the last six months we had seen expectations pricing in 50 basis points in increases for the next year.

It was only in November that’s interest-rate expectations actually turned negative for the RBNZ, and have now returned to the zero level.

Let’s see how the RBNZ follow up their Stability Report’s findings at their rate decision meeting and statement, and see what implications that has for the NZD in the coming weeks.

5. UK Macro Data Key For Pound, BOE Rate Decision May Be Non Factor

The general market consensus is that the Bank of England will expand its quantitative easing beyond what it announced in October, bringing its QE to a total of £275 billion. However that announcement may not come this week when the central bank meets for its latest rate decision on Thursday. It’s already purchasing bonds at the maximum level which implies that the Monetary Policy Committee can wait until early next year to add to its QE purchase program.

From San Francisco Gate: “”Market capacity made it difficult to increase the monthly rate of purchases substantially above what was already under way,” the minutes said. “Some members noted that the balance of risks to inflation” in the bank’s new forecasts “meant that a further expansion of the asset-purchase program might well become warranted in due course.”

We will therefore assess the Pound’s strength this week based more on its macro data including readings on Services PMI as well as BRC retail sales monitor early on Monday, house price data from Halifax on Tuesday, manufacturing and industrial production data on Wednesday, and trade and producer price data on Friday.

• The services PMI report is expected to show slowing expansion, with the index expected to come in at 50.64 November, from 51.3 it October.
• The BRC Retail sales monitor showed that on the year sales were down 0.6% in October and there is no forecast here for November’s reading. However, with the pressures currently being placed on the UK consumer (high inflation, stagnant wages, and climbing unemployment) ir will be important to see if we have another negative print or a bounce-back in spending for the November period.
• Wednesday’s manufacturing and industrial production are expected to show output contracting in both indexes. That should weight on the pound as that will magnify the perception that UK economy is heading towards recession. A negative surprise especially would hurt the pound, though a positive surprise – because of the poor expectations – could give the pound a boost.
• Friday’s producer price data is expected to show output prices of 0.2% on the month.
• Trade balance data continues to show that exports have not picked up the slack for the UK economy in order to counteract weak domestic demand from austerity measures as well as the pressure on consumer’s wallets.

- Nick Nasad is the Chief Market Analyst at FXTimes – provider of Forex News, Analysis, Education, Videos, Charts, and other trading resources.

Information and opinions contained in this report are for educational purposes only and do not constitute an investment advice. While the information contained herein was obtained from sources believed to be reliable, author does not guarantee its accuracy or completeness. FXTimes will not accept liability for any loss of profit or damage which may arise directly, indirectly or consequently from use of or reliance on the trading set-ups or any accompanying chart analysis.