European market outlook week september 5 2011

European market outlook week september 5 2011 ; After the ugliest of jobs reports, a breakdown in Greek debt talks, and news that U.S. regulators are going after banks, Friday is most definitely a risk-off day. And yet FX markets are still taking the next wave of European political risks far too lightly.



On Sunday, the German north-eastern state of Mecklenburg-Vorpommern holds regional elections. Though Chancellor Angela Merkel is expected to pass this test of her coalition, it could raise questions about the depth of parliamentary support she has for expansion of the European Financial Stability Facility that euro-zone leaders agreed to on July 21. A weak Merkel is a weak euro.



On Monday, the lower chamber of the Italian parliament begins debating the latest fiscal package, the program of austerity that was part of the quid-pro-quo in return for the European Central Bank buying Italian bonds. Approval of the measures is expected, but Prime Minister Berlusconi’s move to scrap efforts to delay the retirement age and ditch a tax on the wealthy will leave the government short of cash. The preferred Italian solution: target tax evasion — but we all know how well that has worked in Greece.



On Tuesday, Italian unions will hold a general strike, a big display of the political pressure on Berlusconi.



On Wednesday, the German constitutional court rules on the legality of expanding the powers of the European Financial Stability Facility. It’s likely to uphold the EFSF but if it raises any doubts about it, nerves will be rattled for sure.



And On Thursday, the ECB holds its next policy meeting. At the end of the day, this is where the buck will stop for currency traders. Keep your eye on it.



All this comes against the backdrop of a no-win situation in Greece. With Greek GDP declining to a projected minus-5.0% in the second quarter and showing no sign of rebounding, the “troika” of the IMF, EU and ECB found Athens woefully short on measures to cut its deficit and so packed up and left the city on Friday. That left talks over the next tranche in the country’s bailout program up in the air and thus put in doubt the flow of funds that Greece desperately needs to avoid default.



With the Italy, the third largest economy in the euro zone, now lining up as the next domino to fall, this deteriorating environment will force the ECB to step up bond buying. But there’s an equally important question on what the central bank does with interest rates. And there, the market could get a surprise.



I believe that at the very least the word “vigilance” will be dropped from ECB President Jean-Claude Trichet’s commentary after the meeting. I also think the central bank will suggest leaning toward a cut in interest rates. The market is not at all prepared for this. It has been the strength of German data that has kept the ECB stubborn and German GDP is weakening.