Talking Points

• Dollar, Yen Outperform on Safety Demand as Stocks Slide in Asian Trade
• EU-27 Fails to Agree on Treaty Changes as France Balks at UK Demands
• Watered-Down Euro Debt Crisis Containment Plan Broadly Disappointing
• Aussie, NZ Dollars Sold as Chinese Industrial Output Slows Dramatically
• European Banking Authority Says Banks Must Raise Additional €114.7bil

TheUS Dollar andJapanese Yen pushed broadly higher overnight as news-flow from theEuropean Union leaders’ summit continued to disappoint, sinking Asian stocks and boosting demand for the safe-haven currencies. The MSCI Asia Pacific regional benchmark equity index fell 2 percent. The sentiment-sensitiveAustralian and New Zealand Dollars bore the brunt of the selloff, with downward pressure compounded by signs of slowdown inChina (a key export market for both countries) after data showedIndustrial Production expanded at the slowest pace in over 2 years.

Turning to the Eurozone, markets were already on the defensive heading into the overnight session afterECB President Mario Draghi set off an aggressive selloff across the spectrum of risky assets, stressing the central bank would not circumvent treaties barring it from financing member countries’ debts and adding that the bank doesn’t see a high risk of deflation. Both statements dashedhopes that the ECB was preparing to ramp up bond purchases if only EU leaders were able to secure agreement on substantive fiscal integration.

The bad news continued in Asia as it was revealed that the fullEU-27 failed to agree on proposed changes to governing treaties designed to bolster the bloc’s fiscal governance. The effort was reportedly scuttled by the UK, which insisted on guarantees protecting its finance sector (like exemption from a potential future financial transaction tax) that were opposed by France. Instead, leaders of Eurozone countries plus six voluntary recruits outside the single currency area will sign an agreement at the intergovernmental level.

The remainder of achievements reached so far largely mirrored aFranco-German accord that emerged earlier in the week. Counties that sign up to the arrangement will be required to pass balanced-budget legislation, the creation of the permanent ESM bailout fund (capped at €500 billion and without a banking license enabling it to borrow from the ECB) will be brought forward to July 2012, and member states’ budgets will have to be submitted to the European Commission for review (although it will not be able to veto them). Structural deficits will also be capped at 0.5 percent of GDP, with near-automatic penalties set to kick in for violators.

Rounding out the menu of agreed-upon measures, EU central banks will provide €200 billion to the IMF to help fight the debt crisis, with the majority of the money (€150 billion) coming from Eurozone member states. Also, private-sector involvement (PSI) in shouldering future losses on member countries’ bond holdings will follow IMF rules rather than the haphazard approach taken with Greece and the operation of the EFSF and ESM facilities will be turned over to the ECB. Separately, theEuropean Banking Authority said EU banks will need to raise an additional €114.7 billion in new capital to help them weather the debt crisis.

On balance, this is a disappointing outcome. As wediscussed earlier in the week, these watered-down measures do not go nearly far enough. Of the headline achievements, turning over EFSF/ESM control to the ECB is probably the most significant since the central bank is still largely seen as credible by the financial markets. Otherwise, familiar problems remain. At €500 billion, the ESM is much too small to be a real game-changer considering Germany fiercely opposes running concurrently with the EFSF. Submitting budgets to the EC is pointless without its ability force member states into compliance, and the loopholes built into the penalties for high-debt countries mean their enforcement is suspect. Even the €200 billion provision for the IMF will not be fully confirmed for at least 10 days.

For their part, financial markets seem to be reserving judgment until the summit’s conclusion.S&P 500 stock index futures have erased earlier losses, hinting risk appetite trends have returned to an effectively neutral setting. The sit-down in Brussels remains in focus, with traders paying acute attention to further developments to be revealed either in via official sources or in sidelines commentary. Unless policymakers deliver something substantively stronger than what has already emerged however, risk aversion seems likely to return in force, driving safe-haven currencies higher at the expense of theirrisk-linked counterparts.

Asia Session: What Happened

Euro Session: What to Expect

Critical Levels

---Written byIlya Spivak, Currency Strategist forDailyfx.com

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