With Frayed Nerves, Markets Await European Leaders' Moves

Investors await the final outcome of the European leaders' summit with lowered expectations, after Thursday's stream of disappointments out of Europe rattled markets.

German Chancellor Angela Merkel and French President Nicolas Sarkozy
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German Chancellor Angela Merkel and French President Nicolas Sarkozy

The EU leaders Friday are expected to announce agreement on new rules for tighter fiscal integration, as agreed by German and France earlier in the week. According to news wire reports late Thursday, sources said the new rules were agreed by all 27 EU leaders and include requirements for balanced budgets and automatic sanctions for deficit offenders.

The first unsettling news came early in the day from European Central BankPresident Mario Draghi, who discouraged market expectations that the ECB would serve as lender of last resort and balloon its balance sheet by buying sovereign bonds. Draghi said the current bond purchases would not be "infinite." The ECB did cut interest rates by 0.25 percentage points and extended lending programs to provide more liquidity to banks.

"It's a little scary," said Robert Sinche, head of G-10 currency strategy at RBS. "When there's a problem and a crisis, the Fed in a sense goes out of their way to outline the things they can do, and the ECB tends to outline the things they cannot do."

Also unclear Thursday was the fate of the European bailout funds, the 440 billion euro European Financial Stability Fund , and the ESM (European Stability Mechanism), the future, permanent rescue fund. A draft summit agreement circulated late in the trading session, saying the ESM would be launched in July, earlier than expected and that it would be given bank status. An unnamed German official was nearly immediately quoted as disagreeing with that use of the ESM, driving stocks to their lows of the day.

The Dow ended the day down 198 points at 11,997, and the S&P was down 26 points at 1,234.

U.S. data Friday includes international trade at 8:30 a.m. EST and consumer sentiment for December at 9:55 a.m.

But the focus will be on Europe and the highly anticipated summit that traders Thursday feared would end without workable solutions to contain the sovereign crisis.

"I think they know the stakes are high so this summit won't be over until it's over," Sinche said. "... We're used to analyzing fairly defined outcomes. We don't have well defined models or analysis or data. This is about who is willing to accept what, who is willing to blink, and who is not, and the risk reward for walking out of that is very different for different countries... you have to believe that they believe that failure is not an option, not only for markets but for their own futures."

Sinche said the euro, which was at about 133.41 late in the day was holding up surprisingly well, given the sell off in equities and other risk assets.

"Hopefully they will not leave the markets just hanging into Saturday. That's all you need is yearend liquidity and to have all this happening," he said.

He said the process of resolving the crisis could take several years. "It could be a five or six year process, but the markets are worried about how they're going to fund in the first quarter. Germany is worried about a long term arrangement to make sure this doesn't happen again, and the markets are concerned about how they're going to get from here to the long term. I'm not sure they fully understand it," he said of European leaders.


U.S. data Thursday once more surprised to the upside and showed progress in the economy. Weekly jobless claims fell to a seasonally adjusted 381,000, the lowest level since late February.

But a third quarter report from the Fed showed that household net worth fell the most since the failure of Lehman, as financial assets lost value.

IHS Global Insight economist Gregory Daco said there has been good news on the jobs front. "We've seen ongoing gains on the employment front. The three month moving average was at 128,000, if you exclude the Verizon workers that were on strike. That's relatively good news. The bad news is you still have a lot of people who have been unemployed for quite some time," he said.

Daco notes he reduced his expectations for a U.S. recession to 35 percent from 40 percent because of the improving data.

But the one big risk that hangs over the economy is Europe. "I would put the number one risk for the the U.S. economy being what comes out this weekend, " he said, adding he believes there's still chance for a plan to be announced and that EU leaders were still negotiating.'

Follow Patti Domm on Twitter: @pattidomm