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Markets to Ride Rollercoaster All the Way to EU Summit(s)

Ahead of a weekend summit of European Union leaders to discuss solving the euro zone debt crisis, markets are going through a rollercoaster ride between hope and despair as leaks of possible breakthroughs are followed by denials that a solution is at hand.

EU building flags brussels
EyesWideOpen | Getty Images
EU building flags brussels

Late on Thursday, French President Nicolas Sarkozy and German Chancellor Angela Merkel announced that a second summit was needed next Wednesday, after talks ended without the two reaching an agreement on how to boost the firepower of the single currency area's bailout fund, the European Financial Stability Facility (EFSF) .

"The salvation of the euro zone is yet a moving target," ING analyst Paolo Pizzoli wrote in a note sent to clients Friday morning.

The euro hit session highs Friday, after German finance minister Wolfgang Schaeuble said he hoped for a resolution. According to a Dow Jones report, Schaeuble said he hoped for an agreement on "an efficient mechanism for a new EFSF." The single currency stepped shyly into positive territory after spending the morning in the red, as nervous investors sought to limit exposure ahead of the summit.

Schaeuble also said the situation was "serious" in Europe and is starting to affect the real economy and signaled that the deadline for a solution to the crisis will be the Group of 20 nations summit in Cannes at the beginning of next month.

"These talks are important for the euro and euro zone and we must reach a decision by Nov. 3 and 4," he said, quoted by Dow Jones.

European stocks were trading higher on Friday, but data from Thomson Reuters Datastream showed 30-day implied volatility for the major European indexes hitting their highest in two weeks on Thursday, with the DAX, the CAC 40, the FTSE MIB and the IBEX 35 trading between 39.7 percent and 41.6 percent.

The FTSE 100's implied volatility also rose sharply, but it was still trading at 30.3 percent, much lower than other major stock indexes on the continent.

On Thursday, a leaked guidelines document for the EFSF showed the fund will be allowed to buy euro zone countries' bonds in secondary markets, according to Reuters.

"We're in a situation, if you were scripting a disaster movie, you really couldn't build the tension better," Bill Blain, senior director at Newedge Group, told CNBC.

The time for investors to get off the rollercoaster clearly hasn't arrived yet, analysts said.

"It is again the week of all weeks, the summit of all summits. It is again crunch time in Brussels," ING analyst Carsten Brzeski wrote in a market note.

Deeper Losses for Bondholders?

The anti-crisis package that leaders are likely to propose will have four broad elements: bank recapitalization, leveraging the EFSF, further restructuring of Greek sovereign debt , and new economic governance, according to Brzeski.

"However, as so often is the case, the devil is in the details—and it will be in each of these four elements," Brzeski added.

Bank recapitalization should help banks somewhat offset the negative impact from a possible restructuring of Greek debt, but coming up with a detailed plan will take time. The most likely outcome, the ING analyst said, would be a general agreement on higher Tier 1 capital ratios, with a timetable on how and when to raise capital.

On the issue of restructuring Greek debt, a renegotiation of the agreement reached in July, which stipulated a voluntary haircut of 21 percent on Greek bonds for the private sector, is considered by many to be in the cards, with the private sector forced to take deeper losses.

Germany is asking for a 50 percent loss to be taken by the banks that loaned Greece money, a scenario dubbed "very aggressive" by an EU official speaking to Reuters.

"Let's be serious, everybody knows that a 50 percent haircut, as Germany is asking for, is not a voluntary move," Reuters quoted the official as saying.

Other scenarios call for a 40 percent writedown while some radical analysts have even spoken about a 100 percent writedown.

According to guidelines on the euro zone's rescue fund seen by Reuters correspondents, the EFSF will be used to buy bondsboth in primary and in secondary markets, though only for countries which respected their deficit-cutting commitments under the EU budget rules, the Stability and Growth Pact.

Boosting the EFSF's Firepower

Leveraging the EFSF, and how to it, is the biggest bone of contention—one so big that it means a second summit must be organized next Wednesday as Sunday's summit is now not seen as sufficient for reaching an agreement.

France thinks the best way to leverage the fund is to turn it into a bank and let it access funding from the European Central Bank (ECB) , an idea opposed both by Germany and by the ECB.

On Friday, Germany's government spokesman reiterated the country's position that a leveraging of the EFSF via the ECB was out of the question and Merkel herself repeated this stance to her party, according to Reuters.

"The path is closed for using the ECB to ease liquidity problems," Merkel told her conservative parliamentary caucus in Berlin, according to participants at a closed-door meeting quoted by the news agency.

"The uncertainty has resulted in a flight from risk, hitting stock and bond markets in the U.S., Europe and emerging markets, where currencies have also suffered," Stephen King, chief economist at HSBC, wrote in a note for markets.

About 10 European banks and insurers sent a letter to the EFSF supporting a proposal that it takes part in insuring euro zone sovereign bonds, to help sovereigns gain access to private funding at sustainable rates, according to reports by Reuters and Dow Jones.

Commerzbank, Deutsche Bank, Generali, Mediobanca, MunichRe, PIMCO, and Unicredit are among the signatories of the letter, according to an IFR report.

Politicians, such as Austria's economy minister, have warned against too much optimism about the summit's outcome. Economy Minister Reinhold Mitterlehner said that European countries were not working as a team on solving the crisis.

"The exact opposite is happening. Before every summit such as tomorrow and the day after, France and Germany go public prematurely with suggestions that in part are seen either as promises toward solving the problem, or in part are shot down even before they have been discussed," Mitterlehner said, quoted by Reuters.

Such procrastination reflects a lack of political will to deal with the potential cost of supporting the euro zone, according to analysts from Lloyds Bank Corporate Markets.

There is no "quick fix" to the underlying competitiveness problems in the euro zone's periphery countries, while for the big, core economies, "the price of drawing a line under current concerns is simply too high," Lloyds Bank analysts wrote.

"It suggests that, barring a major surprise in the coming days, financial markets tensions will persist for the coming months at least," they added.

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