A crucial week for the credibility of the European Union came to an end, and if one is to be guided by the latest price action seen in the bloc's currency, it may be safe to say that goals were achieved with remarkable results. Investors around the world had a sight of relief, celebrating the fact that Europeans came together to bring about a so called comprehensive rescue plan for the region.

After marathon talks, European leaders managed to ease in a rather exaggerated fashion as per market moves, fears of debt spreading across the globe. Markets heard what they wanted as Europe continues to excel on keep playing the game of kicking the “crisis can” down the road, although this time, the kicking comes with the prospects of an inflated EFSF, and banks told to raise capital and accept 50% of losses in its Greek bonds.

The chatter of further easing in the United States picking up momentum, combined with the markets, quite erratically from a fundamentally coherent standpoint, getting way ahead of itself, triggered the perfect storm to engineer a short-covering rally of colossal proportions in the FX market, with risky currencies like EUR, AUD, stuffed with an overdose of pips. Investors had to cover their Euro shorts by buying the currency back after the broad-based Euro bearish stance running into this week's risk event.

The plan to deal with the Euro crisis, at first sight, and despite there is a worrying absence of concrete details, contains all the market had been hoping for, including the delivery of the much-needed hard numbers. The bulk of these details had been leaked earlier on the week, including higher capital requirements for banks and increasing the EFSF firepower, yet the explosion of risk appetite was awaiting... markets needed reassurance that all the pieces were put together. Politicians knew they had to deliver to save the union from drowning into more financial misery, even if having an almost sleepless Thursday night.

First piece: Bank recapitalization
During the extended EU summit from Wednesday, details over how to go about recapitalizing troubled banks were finally confirmed. They will be required to have a 9% Tier 1 capital ratio by July 2012, with estimates looking at roughly €106 billion as the additional capital to be raised (two-thirds of which is related to Greece, Spain and Italy). However, still needs to be seen where that additional funding will come from – either by banks raising new capital in the form of issuing new debt or by selling existing assets to reduce the size of their balance sheets.

Second piece: Bolster the EU bailout fund
Confirmation that a a much powerful bailout fund will be ready to save peripheral nations' finances was also announces. This will be achieved through the very same method that triggered the economic meltdown from 2008, that is, leveraging the fund by no less than four folds from the initial EUR440 billion. As explained by Jeff Harding at the Daily Capitalist: “The EFSF may issue up to €440 of bonds secured by €780 of EMU member sovereign guarantees. Bonds will be issued in exchange for the Greek bonds (which are, in effect, in default). They will also be used to back the bonds of Spain, Italy, Portugal and perhaps others.”

Third piece: Greek haircuts
However, something was missing, a piece necessary to understand how politicians would tackle the unsustainable debt burden Greece has on its shoulders... Skepticism over reaching an agreement over the depth of the losses to impose on Greek bondholders had grown significantly , yet through much push and pull, deliberations, marathon talks and taking hostage over 500 reporters up until 4am Brussels local time, European leaders concluded their summit confirming they had reached an agreement with Europe's largest banks for a 50% Greek haircut, putting the cherry on the cake, a move ultimately enacted to ensure the stability of the Euro-zone, at least in the near-term.

Euro outlook: opinion from analysts
Looking at how the Euro may perform going forward, Kathy Lien, Director of Currency Research at GFT, expects the rally in the Euro to continue for the time being, although she warned: “Traders need to be aware that as soon as a piece of bad news hits, the currency could give up its gains quickly because the rescue plan does not resolve all of the region's troubles. Greater financial commitments means greater austerity which can result in slower growth.  However in the meantime, the momentum in the market is on the side of euro bulls.”

Taking a second opinion on board, the FX team at Brown Brothers Harriman, also supports the bullish bias in the short term: “We still think the euro is likely to come under pressure over the next few months in part as the ECB is likely to cut rates in December to support euro zone growth but over the short-term we expect the short squeeze and  the improvement in market sentiment to keep the euro bid into the ECB meeting.  A convincing break of the 200dma and an upside cross of the 100 and 200dma is likely to see the euro target its recent high near 1.45.”

Chris Vecchio, Currency Analyst at DailyFX, gives a third take, saying that while the situation remains dicey at best, “it is likely that the higher yielding currencies and risk-correlated assets will find bids higher on news of relief to credit markets – this has occurred and will likely continue through the end of the month. If a liquidity crunch is ruled out in the short-term, then the U.S. Dollar is likely to come under further pressure as investors flee safer assets and shift capital into riskier investments, knowing full-well that their investments are back-stopped by Euro-zone measures.”

Moving forward

In the weeks to follow, there is still much homework to get done. First of all, amid the reluctance of the ECB to accept the consequences of buying distressed assets, Europe needs to encourage Chinese participation in the bailout fund. Nicolas Sarkozy, aware of how urgent events need to move, pitched the Chinese Premier Hu Jintao through a telephone conversation earlier on Friday. The big Panda's president, from still a very cautious stance, gave hopeful signs of China's willingness to cooperate closely with the G20 in order to strengthen global economy.

Reports suggest China is likely to contribute to the EU bail-out fund, however, according to the FT: "The scope of its involvement will depend on European leaders satisfying some key conditions, two senior advisers to the Chinese government have told the Financial Times." The conditions to be met, the FT explains, are: "Contributions from other countries and Beijing being given strong guarantees on the safety of its investment, according to Li Daokui, an academic member of China’s central bank monetary policy committee, and Yu Yongding, a former member of that committee."

As Ashraf Laidi, Founder at Ashraf Laidi.com puts it: “Rome was not built in a day, neither will the EFSF.” Picking in the same line, getting the BRICs on board to support the EFSF is just one of many factors that will make up the complex equation of defining the specifics of the whole EU crisis plan. Among other question marks to be filled are, as rightly outlined by Bundesbank President Weidmann last Thursday, how haircuts will be implemented or whether or not the EFSF leverage bring too much risk. More clarity into the plan will likely be ironed out at the Nov EZ FinMin meeting.

Another hot subject likely to make headlines next week will be how the Italian Government, headed by the ever controversial Berlusconi, finds its way through the political mess they are trapped into and bring forward much needed fiscal reforms to satisfy their European counterparts. New austerity measures need to be urgently implemented, and despite Berlusconi pledged action will be taken by November 15, fears are that little will get done until early next year, when “il cavalieri” (as he is know in Italy) plans to resign from his post to give way to a new breeze of political freshness into the country. fact move lower from here.

The Wells Fargo FX team also remains cautious, pointing that European plans are lacking in detail and face clear implementation risks. In particular, the team sees question marks over the EFSF leverage and the plan’s effectiveness in bringing down borrowing costs for Italy and Spain on a sustained basis. Moreover, the team believes the euro is not reflecting a weaker Eurozone economy and increased prospects for ECB policy easing.

As reported by the Brown Brothers Harriman FX team: "Another focal point for next week will be on policy and macro data with the Mario Draghi set to take the helm at the ECB and the US October payrolls report expected to take center stage.  While we doubt the euro zone package is likely to be game changer over the medium-term, we do think stretched positioning and the reduction of global tail risks are likely to give the euro (and other growth sensitive) more room to run ahead of the ECB meeting.”