It is difficult to really gauge the state of the Eurozone economy or for that matter the chances of a solution being found from the value of the currency against either individual currencies or a basket.  Bond markets, the ability of individual countries to fund themselves and the prospect for growth in the economy and a fall in unemployment should be used. However, the state of those criteria will drive the currency.

 After falling to fresh multi-year lows through the first half of the year, the EURUSD remains surprisingly resilient. The recovery in Italian and Spanish bond yields is probably an illusion created by Sr. Draghi’s “we will do what it takes” speech. 

After all is there anyone in the first week of September that believes the Italian or Spanish economies are stronger than they were in June?

Spanish banks received more than  Eur 100 bio. in bailouts and still need more. Italy’s austerity plans while holding for now will start to bite in the Autumn/Winter and we will see then just how “on-side” the Italian people are. Greece faces the real possibility of being kicked out of the Eurozone in the coming weeks.

 The currency has been on quite a ride over the past few months. A lot of that is due to a lack of liquidity over the summer coupled with a distinct reluctance on behalf of the big players to take positions. Having said that, it is easy in hindsight to match the market moves to fundamental market moving news stories. That reminds me to talk about fundamental vs. technical analysis but that is for another day!

There are two important story lines to follow to understand the ebbs and flows of the crisis and the future of the Euro, at least through the rest of 2012. It is little exaggeration to claim that the outcomes of these events could decide the performance of financial markets over the rest of 2012 and beyond.

So, the two most important runaway trains hurtling down the track are:

Does the European Central Bank bailout Italy and Spain via a major bond-buying program? And Does Greece exit the Euro-zone?

As the Euro-zone’s third and fourth-largest members, Italy and Spain likely hold the key to the Euro’s survival. When ECB President Mario Draghi said that he would do “whatever it takes” to preserve the Euro, many believed that this meant the central bank would institute a ceiling on Italian and Spanish government bond yields—in effect bailing out two of the Euro’s largest debtors.

 Investors in turn became less concerned about holding Euro-denominated assets . Since Draghi’s announcement on August 2, the EURUSD has strengthened by 3.2% and the US S&P 500 is up 4.5%. But this is not a sustainable position. The ECB will have to buy a majority of primary Italian bonds and investors will have a backstop for their secondary market purchases.

 At the present time, neither Italy nor Spain is in line to receive a bailout. But if Italian and Spanish bond yields linger above key levels for too long (greater than 5% for 2-year notes and greater than 7% for 10-year notes), bailouts will be inevitable.

 If a bailout occurs or even if it doesn’t, the currency as an indicator of the economy has to fall.

The time is fast approaching for a decision on Greece. There has been so much rhetoric it’s now impossible to say there is an official Eurozone stance on the subject. We have “of course we want/need Greece to stay in the Euro” coupled with “  Greece can’t perform its bailout conditions they will have to leave”.  The austerity required now in Greece is unpopular to put it mildly, imagine how bad it’s going to get if they actually make an effort to comply! A further election where the coalition to fail would be a disaster as the far left would almost certainly gain control and Greece would leave of its own volition.

The New Democracy coalition government needs to get through another €11.5 billion in spending cuts for 2013 to 2014. The timing of this decision is very important: the European Troika (the European Central Bank, the European Commission, and the International Monetary Fund) has declined to extend further aid to Greece unless these cuts go through. With the country facing a cash drought in the near-future, it is difficult to say that Greece will make it through the next few weeks unscathed.

As things stand, there is no major safety net in place as the European Stability Mechanism (ESM) is not yet in force and there is no major ECB bond program in place. A Greek exit from the Euro-zone would force the Euro/US Dollar and S&P 500 to fall back quickly and sharply.

 In the best case scenario, in which the ECB embarks on a debt monetization path by purchasing Italian and Spanish debt indefinitely, this would still plague the Euro as it would artificially dilute the common currency’s value; and in this case, the EURUSD could very-well trade towards 1.1000 near the start of 2013.

Germany has a major issue with the bond purchase scheme and still has to rule on whether the EFSF is constitutionally legal.