Stock market surge hints at hope for end to Europe's debt crisis

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Investors are jumping in and out of bets on the euro crisis in increasingly rapid-fire moves, sensing a resolution is near after two years of troubles that threaten to tear the monetary union apart.

Amid mixed signals and a flood of proposals – the latest a push toward fiscal integration of the 17-member euro zone – investors are putting into practice what they learned in 2008: That in risky and uncertain markets the spoils go to the nimble and cash-rich.

Markets used the latest threads of hope from Europe to stitch together a dramatic rally Monday, but it smacked more of opportunism than optimism. In response to more rumblings out of Europe that were potentially positive but thin in substance, investors flooded back into assets that they had all but abandoned in recent weeks amid fears that the debt troubles could escalate in a new global financial crisis.

The volatility suggests that the crisis is fast approaching a turning point, one way or the other. Investors expect fireworks in the next two weeks, leading up to the Dec. 9 European Union summit.

One goal of that summit is to prevent the crisis from swamping Italy, Europe's most indebted economy. Italy is the euro zone's third-biggest economy, with output bigger than Canada's. Its financial collapse would tear the euro zone apart and plunge Europe into deep recession, taking North America down with it.

The Organization for Economic Co-operation and Development warned on Monday that the euro zone risked a severe recession unless European leaders provide "credible and large enough firepower" to prevent the contagion from spreading. The OECD expects 0.2 per cent growth for all of Europe in 2012 compared to its last forecast of 2 per cent.

The debt crisis and the economic outlook are so dire that investors are assuming that a cure – finally – is imminent because another round of inadequate responses would destroy the common currency.

In a note to clients, Deutsche Bank's Gilles Moec and Mark Wall said the "good news is that the worse the economic outlook becomes, the more likely the [European Central Bank]will take more aggressive steps" to tackle the debt crisis.

A key to Monday's mood swing were reports that the euro zone is considering fiscal integration and discipline measures, which would see national budgets examined and approved by the European Commission to ensure they are sustainable and would not jeopardize debt and budget deficit limits.

"We won't be able to save the euro if we don't accept that national budgets will have to be a bit more controlled than in the past," France's Agriculture Minister, Bruno Le Maire, told Europe 1 radio.

There was also talk that the International Monetary Fund is preparing a €600-billion ($826-billion) bailout package for debt-addled Italy – although the IMF flatly denied the reports – and that Europe's rescue fund, the European Financial Stability Facility (EFSF), might take on an expanded role.

Europe's deepening woes this month have prompted investors to unload higher-risk assets such as equities and commodities in favour of cash and highly liquid U.S. government bonds to build their defences against the threat of another 2008-style financial crisis.

The outburst of hope in Europe on Monday spurred buyers to put some of that cash back to work in markets that have become much cheaper over the past two weeks.

"This is a market of agility," said Stevyn Schutzman, global head of fixed income and currency strategy at Royal Bank of Canada's investment arm in New York. "But with that agility, you're going to have a lot of volatility."

He said traders are now routinely positioning themselves to be able to get quickly in and out of investments as the flow of news and the markets' mood warrants – especially coming out of weekends, when political developments out of Europe have routinely shaken up investor sentiment while the markets sleep.

In addition to the notion of a euro zone fiscal union – a concept unthinkable among the region's leaders a few months ago – there is a growing belief that a scaling-up of the EFSF will be a crucial part of the rescue attempt.

The enlarged EFSF might be able to buy sovereign bonds on the secondary market along with the European Central Bank, which so far has been reluctant to buy more than a smattering of bonds.

The EFSF, which now has €440-billion of borrowing capacity, may also begin insuring the first 20 or 30 per cent of the losses of the newly issued bonds of troubled countries.