EU Summit Agreement lifts Stock Markets and the Euro

Eurozone leaders agreed in the early hours of Friday morning steps to move towards a closer banking union and use the European Stability Mechanism (ESM) to buy up sovereign bonds without forcing countries to adopt fresh austerity measures alongside the removal of senior creditor status, which is designed to cool Italian and Spanish bond yields.

Leaders also agreed for the ESM (or EFSF until the ESM becomes available) to lend directly to banks and create a single banking supervisor, in a move to make the euro, according to Herman Van Rompuy, an ‘irreversible project’.

The reaction in the markets has been positive and quick
The FTSE 100 gained over 1% immediately upon the opening of trading on Friday morning, with 2% gains seen in the German DAX and French CAC Indices. Spanish and Italian benchmark stock indices rallied the most in European trading, as one would expect given the announcements immediately benefit these countries and their banks, gaining over 2.3% by mid morning. The euro jumped over 1% higher against the US dollar.

At the same time, benchmark Spanish 10-year bond yields have fallen by 25 basis points, whilst Italian 10-year yields have also fallen 20 basis points to reside back below the 6% level. The removal of senior creditor status does much to instil greater confidence to private lenders that in the event of a Spanish or Italian default, their interests won’t be left at the side of the road.

Growth policies and greater deficit controls were put on the back burner to allow leaders to focus primarily on the immediate concerns of the market, which is bank recapitalisation, and direct lending to states through stressed bond markets.

Merkel’s ‘about turn’ is perhaps most significant
Of course, the ‘pincer move’ that appears to have taken place by Hollande to support Italy and Spain and soften his support for German lead initiatives is perhaps the key deciding factor to a softening of Merkel’s stubbornness this time around. Indeed, this was hinted towards yesterday when Hollande said that he “will work on more immediate steps to support countries under market pressure.”

Perhaps however the most significant element of the EU Summit agreement is that Merkel softened her stance on fresh austerity alongside fiscal support in the first sign of changing tides of power within the euro block. Merkel was simply out fought by the many in this decision and her failure to agree to measures to help immediate bank recapitalisation and sovereign bond yields could have left her isolated. So whilst the agreements made are a good step in the right direction for Europe, the key element within this Summit is Merkel’s about turn. The interesting element know will be whether this is a sign of things to come or whether she was simply forced into a backdown in the face of a strong eurozone majority.

That said, a degree of caution is needed before investors get too heavily sold into the ‘success’ of this morning’s agreements. We still don’t know much of the fine print behind these agreements, which is set to be made clear later and there could be many hurdles to jump yet. We have already seen claims by government officials that may indicate the difficulty it could be for these measures to pass through, such as the German parliament must approve ESM direct aid for eurozone banks. At the same time, the evidence of the past two years has seen many headline agreements made at EU Summits that are then deconstructed and watered down by the time it comes to implementation.

The success and failures of this summit will be judged in 6 to 12 months time, not today.

Until we know the specific details of what process will follow for direct bond buying and bank recapitalisation, a pause for breath is warranted.