Will the Euro Crisis Strike Back?

In recent weeks the steady stock market rally, events in the Middle East and trouble with state finances in the US have taken center stage and pushed the euro crisis to the back of investor's minds.

Following some fears in the week of Jan 10th over bond auctions in Spain and Portugal the market has largely shrugged off fears over a bailout for Lisbon or Angela Merkel's war on fiscal irresponsibility and the EU's lack of competitiveness.

Over the weekend, European Central Bank President Jean-Claude Trichet called on Portugal and the rest of the euro zone to get their houses in order and get ahead of the market.

"We call on all governments, without any exception, first to apply the plan that they have ... as rigorously, convincingly and ethically as possibly, and they have themselves to be ahead of the curve in all respects," Trichet said.

The IMF has called on the euro zone to have a credible plan in place before EU heads of state meet next month and reports indicate the Germans are again pushing for Lisbon to agree to a bailout as soon as possible.

The bond market remains on high alert with bond yields across Europe's periphery at levels that were, just a few months ago, seen as crisis-inducing.

Late last week we saw some major trades against the euro in the Chicago pits and two Irish banks added to investor nerves by using the ECB's marginal lending facility for technical reasons related to their imminent winding down.

The Irish election and the chance of Irish voters rejecting the terms of the recent EU/IMF bailout are adding to the uncertainty going into next month's crucial heads of state summit.

What Next?

If previous EU responses to the euro crisis are any guide, investors should not be expecting a highly-coordinated, shock-and-awe approach like those we have seen from the US authorities.

Instead, expect to see an increasingly bitter and public debate over the following issues.

Who will replace Trichet at the ECB and will that person be a German? Will the cost of Germany underwriting an enlarged European Financial Stability Fund be able to deal with a Portuguese bailout and frighten off the bond vigilantes from Spain?

Now the key concern for the political debate that is already underway behind closed doors is German public opinion. One of two things have to happen if Angela Merkel is going to be able to look her public and coalition partners in the eye by April.

As Wolfgang Münchau eloquently points out in and article in Monday's FT, Merkel needs one of two outcomes in the next few weeks.

Either she gets a German running the ECB when Trichet stands down later this year, or she gets terms on competitiveness and fiscal responsibility from the rest of the euro zone.

Following Axel Weber's decision not to stand for the ECB presidency, both Merkel and the rest of Europe are between a rock and a hard place.

As witnessed by the Irish election, voters and therefore governments on Europe's highly indebted periphery, appear unwilling to sign up to further austerity measures or economic pain.

This could therefore mean Angela Merkel is unable to secure the terms she needs to sell further German money being spent on the euro crisis to her voters.

She would then need a German running the ECB by November, which could see a last minute scramble for a German candidate following failure to get a harsh enough deal for German voters from her EU partners.

How this plays out in the market over the next few weeks is difficult to call, but expect a volatile month for both the euro and the European bond market.