Tue 11/29/11 11:24 AM – ST Rally, but Euro Collapse in 2012?

After 7 down days in a row, the market rallied yesterday on better than expected shopping news for the Thanksgiving weekend and Cyber Monday and news in Europe that the biggest countries were pushing for a closer fiscal union for the Eurozone (17 countries) and perhaps the European Common Market as well (27 countries). This rally may have some legs, short-term.

Any tighter European fiscal union agreement would require amendments to the existing treaties that underpin both blocs and more likely will require new treaties. Remember, everything has to be unanimous and agreements would need ratification by the various parliaments. New treaties would likely take months to write and get approved down the line.

Meanwhile, interest rates on sovereign bonds (those issued by countries) continue to climb rapidly. Today, Italy had to pay 7.89% on three-year bonds and 7.56% on 10-year paper, according to the WSJ. Compare that to the 4.5% rate Italy paid during the summer. Not only are the new rates too high for Italy to pay if it has to keep replacing maturing debt at that rate but the rate on the shorter paper is higher than on the longer. That nearly always signals recession and indeed, economists have changed their forecast for Italy to shrinking 1/2% – 1% next year. Thursday, Spain has an auction scheduled and it may be just as ugly.

It is becoming increasingly likely that the Euro currency experiment will fail in 2012. Southern Europe is just not economically competitive with Northern Europe and is falling into recession again. Higher interest rates and austerity programs will only make it worse. While the European Central Bank (ECB) is viewed as the savior, it may be that even their changing course to buy massive amounts of bonds may not save the day.

Meanwhile, some European governments have told their banks in no uncertain way but still behind the scenes that it will not go well with the banks if they keep selling sovereign bonds or refuse to participate in the auctions by buying even more of this troubled paper. It apparently didn’t help in today’s Italian auction, given the very high rates.

If the Euro ship keeps rattling so hard and beginning to sink, it will affect markets all over the world in 2012. First, it will drag world growth lower. Second, it will drive money from risk assets like stocks and commodities to cash and bonds. Third, it will drive investment money out of Europe to the US, China, Japan and perhaps other places as well. 2012 may be even more volatile than 2011.