Courtesy of Benzinga.
The leaders of most European Union countries signed a new fiscal treaty aimed at preventing another sovereign debt crisis from happening. The leaders also hope that the treaty, also referred to as the fiscal compact, will reassure the markets that troubled euro zone members like Spain and Italy will stick to austerity measures and balance their budgets.
The euro zone got into the sovereign debt crisis because euro zone members often broke EU deficit rules and, in the cases of some countries like Greece, actively tried to hide their out of control deficits from the rest of the European Union. The fiscal compact that EU leaders just agreed to is aimed at preventing another deficit crisis by requiring that national budgets either be in balance or be in surplus and contains correction mechanisms that will automatically go into effect if the balanced budget rule is broken by any country.
The fiscal compact was signed by 25 of the 27 European Union leaders, with the notable exception the United Kingdom and the Czech Republic. The United Kingdom’s refusal to sign the treaty wasn’t totally unexpected because UK Prime Minister David Cameron had refused to agree to an earlier pact on the grounds that he wanted guaranteed protections for the United Kingdom’s financial sector. However, passage of the fiscal compact is considered so important that it only requires 12 of the 17 euro zone countries to ratify it.
With an overwhelming majority of European leaders approving the fiscal compact, it’s likely that it will pass the final obstacle for approval when it is sent to national parliaments who will decide the fiscal compact’s fate. There’s very little incentive to vote against the fiscal compact because any government that did so would be ineligible for future bailouts if it were to get into financial trouble. Voting no against the fiscal compact could also send a message that the country that did so would continue to run excessive deficits, which could send that countries borrowing costs higher.
Ireland is one of the few countries that may vote against the new fiscal treaty because Irish voters will decide whether or not to pass the fiscal compact in a nationwide referendum. It seems like it would be in Ireland’s best interests to sign the treaty because the country has already received a bailout from the European Union and might not want to risk receiving future aid because it voted against a treaty that is almost guaranteed to pass. However, much of the Irish population is resentful about the terms of the bailout and could opt to vote against the treaty.
If the markets believe the fiscal compact will accomplish the goal of maintaining fiscal discipline throughout the euro zone, the borrowing costs of countries like Spain and Italy should fall and the chances of another sovereign debt crisis will also diminish drastically.
Spain and Italy have benefited from two rounds of the European Central Bank (ECB) providing cheap loans to euro zone banks, which used much of the money to buy the high interest debt of the two troubled euro zone countries. However, the European Central Bank has signaled that it will stop providing euro zone banks with cheap loans. When the money runs out, the yields that Spain and Italy must pay investors could skyrocket if the market feels that the two countries are no closer to getting their finances in order.
With the passage of the fiscal compact, it’s hoped that a surge in euro zone debt yields can be avoided and the European Central Bank can shift its focus elsewhere.
Traders who believe that passage of the fiscal compact will drive down euro zone borrowing costs and help end Europe’s sovereign debt crisis might want to consider the following trades:
- Buy European financial stocks like Barclays (NYSE: BCS), Banco Santander (NYSE: STD) and Deutsche Bank (NYSE: DB) or the Ishares MSCI Europe Financials Sector Index Fund (NASDAQ: EUFN). If Europe can put the sovereign debt crisis behind it, European financial stocks could be among the biggest gainers.
Traders who believe that a Greek default is all but inevitable and will lead to investors dumping euro zone bonds may consider alternative positions:
- Shares of the ProShares UltraShort Euro (NYSE: EUO), the CurrencyShares Swiss Franc Trust (NYSE: FXF) and the CurrencyShares Japanese Yen Trust (NYSE: FXY) could all be big gainers if a European shock leads to investors dumping euros in favor of Swiss francs and Japanese yen.
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