• Germany 1, Italy 2!
• Oh what a beautiful ‘risk-on’ morning!
• A dawn chorus of pips squeaking

After another day yesterday when forex traders watched the EU Summit paralysis extend towards the month/quarter/half year end, today has dawned with a complete turnaround. In response to an apparent late night capitulation on the part of German Chancellor Merkel to demands by Italian and Spanish FinMins for euro zone aid to bring down their rocketing borrowing costs, European markets have staged a massive rally. Early trading saw futures climbing across the board. The FTSE 100, DAX and CAC have all popped up, with even Spain's IBEX and Italy's FTSE MIB respectively 4.05 percent and 3.07 percent higher.

Speaking first thing this morning, European Council chairman Herman Van Rompuy appeared palpably relieve, especially as only hours beforehand a stand-off between Spain and Italy and Germany looked unlikely to be resolved. At an unscheduled news conference early this morning, Mr Van Rompuy announced sweeping changes to Europe’s bailout facilities in an attempt to ring-fence Spain and Italy from the grip of bond ‘vigilantes’. As his words reverberated around dealing rooms, risk assets perked up and the euro jumped nearly 200 pips.

Van Rompuy said the aim was to create a supervisory mechanism for euro zone banks involving the European Central Bank to break the "vicious circle" of dependence between banks and sovereign governments. “We are opening the possibility to countries that are well behaving to make use of financial stability instruments in order to reassure markets and to get again some stability around some of the sovereign bonds of our member states. The aim is of course to make the euro an irreversible project.”

As to a finer analysis of what this breakthrough does, I heard from Forex.com’s research director, Kathleen Brooks, who opines how, in the first instance, “euro zone authorities have attempted to break the toxic link between banks and sovereigns. The move on Spain is extremely positive in our view,” says Brooks. “Although it doesn’t irradiate the problem of bad loans on Spain’s banks’ balance sheets, it does mean that banking debt won’t clog up Spain’s sovereign balance sheet that was relatively healthy before the banks started to fail. This should reduce Spain’s borrowing costs in the short to medium term.”

It also demonstrates how the Northern bloc of single currency nations, headed by Germany, who had been against allowing the ESM to buy sovereign debt, is collectively willing to cede ground as the EU tries to solve this sovereign debt crisis.

“The move on scrapping credit seniority for bailout loans to Spain’s banks is a very positive move to us as it encourages the private sector to invest in Spain and Italy’s sovereign debt. Only yesterday the Finnish PM spoke out against this…” says Kathleen Brooks, who also cautioned that Germany and co. won’t be “hoodwinked at this summit. A central banking authority marks a big change for Europe,” she insists, concluding: “It scraps the 17 individual authorities and should help enforce re-capitalisation rules across the continent and allow European banks’ capital levels to get up to the same levels as their US counterparts.”

Also, of course, a banking union could also be a pre-curser to fiscal union, which many people think is the only way to save the currency bloc.

Market moves

Generally, then, the overnight news can be seen as risk positive; hence the surge in commodities, stocks, the euro and commodity currencies. It may also cool demand for the safer havens of the dollar and yen. Eurodollar moved sharply higher in the Asian session 1.2630 is the top on forex charts for now. Looking ahead, we have seen the euro rally when credit risk in Europe’s periphery is reduced. Thus, look to the Spanish and Italian bond markets for more direction.

Kathleen Brooks believes the recent action, although not the end of the road for the sovereign debt crisis, will help to ease sovereign strains in Italy and Spain. “Thus, the markets may well extend their rally in the near to medium term and we could see a move towards 1.2650 first then potentially to 1.2750,” she says. “But the prospect of a rate cut by the ECB next week could limit the euro’s gains. Also, the rally could fade if the markets feel like to make a real difference the EFSF/ ESM need more money.”

Drew Hillier. Editor, ForexSpace.com