Markets Give Up Hopes For Lasting Euro Zone Solution

After another week of confusion and turmoil in Europe, investors are ditching whatever hopes they once had for a conclusive solution to the debt crisis.

That may foreshadow a gloomy holiday season in markets, especially if wary investors opt to reduce risk in their portfolios and take refuge in U.S. Treasuries and the dollar.

Just weeks after it seemed leaders had drafted a master plan to solve the crisis, doubts rose about whether Greece would back a 130 billion-euro bailout.

Disaster may have been averted when Greece, under fierce EU pressure, agreed over the weekend to form a new government that would approve the deal and stave off bankruptcy.

But that did little to calm investors, who were already looking ahead to the next problem: Italy. Italian bond yields hit a euro-era high of 6.4 percent Friday, raising fears the country may soon need a Greece-style emergency bailout.

The Greek agreement may spark a brief relief rally, said Alan Ruskin, head of global G10 currency strategy at Deutsche Bank. But it won't last and we will soon go back to focusing on Italy.

At the end of the day, it does seem like a grand plan is elusive at best, said David Ader, head of government bond strategy at CRT Capital Group in Stamford, Connecticut.

We've seen one European bank and one U.S. brokerage fail. We know there are strains for French banks. We're wondering how long it will be before Greek default worries spread to Italy and Spain, he said. In a situation like that, money managers are going to decide to simply take their risk down.

FLIGHT TO SAFETY

Investors are betting the market will see evidence of that as soon as this week, as flight-to-safety flows help boost U.S. Treasury debt, lift the dollar against the euro and weigh on stock markets around the world.

The biggest fear is that a disorderly default in Greece or elsewhere would ripple across the global financial market the same way the Lehman Brothers collapse did in 2008. That, investors fear, would probably be enough to plunge the global economy into recession.

This is going to be pretty negative news for risk markets, said Jack Ablin, chief investment officer at Harris Private Bank in Chicago. We are going to see a continued flight-to-quality tomorrow.

Benchmark U.S. 10-year note yields dropped more than 29 basis points in the past week and a half as worries about Europe overshadowed signs of economic improvement in America.

Ashraf Laidi, CEO of Intermarket Strategy in London, said he expected the euro to struggle again this week after losing nearly 3 percent against the dollar last week. By year end, he said it could fall below $1.30. It was around $1.38 Friday.

This past week really raised some tricky questions, he said. For the first time I can remember, the possibility that Greece really could leave the euro zone was being talked about in cafes and bars as well as on trading desks.

The weekend deal in Greece may stabilize things a bit in that it suggests Greece will keep the emergency funds flowing while making the tough spending cuts needed to get its fiscal house in order.

What we had been afraid of was a stalemate. Now it seems the hard cuts will be made. I think equity markets will cheer this, said Michael Yoshikami, president and chief investment officer at YCMNET Advisors in Walnut Creek, California.

The cheering may not last long, though.

These 24-hour risk-on rallies, I don't know how much longer people are going to be willing to do that, said Ader. Sell-offs are getting deeper because the rallies are only short-covering moves. People are not getting long and putting on bets that everything is suddenly OK.

FROM GREECE TO ITALY

Deutsche Bank's Ruskin said the focus is likely to shift quickly from Greece to Italy in the weeks ahead, and that should mean more volatility and unwillingness to take on risk.

Italy's debt-to-output ratio stands at 120 percent, second only to Greece in the 17-country euro zone, and its borrowing costs are rising.

Prime Minister Silvio Berlusconi recently refused a loan offer by the International Monetary Fund and his government may be on the verge of collapse.

Berlusconi says Italians are not feeling the crisis but that's because the European Central Bank has been providing high levels of liquidity at low interest rates and buying Italian bonds, Ruskin said. That begs the question, should the ECB stop that to show them this is really a crisis?

I have to believe a lot of investors like me are thinking this could be the start of Italy week, said James Paulsen, chief investment strategist at Wells Capital Management in Minneapolis. Italy is going to rapidly rise on investor radar screens and may be the bigger story.