"The trend so far in this whole crisis is when the pressure gets really on, Germany agrees to more incremental moves towards fiscal union. Ultimately, I'm expecting that to be the end game. I'm expecting sooner or later the ECB to put up the white flag and engage in unsterilized monetization purchases of euro zone government debt. However, the quid pro quo for Germany will be an insistence that real fiscal safeguards are put in, European treasury set up, power to raise taxes, issue euro bonds. I believe this is the end game and the only issue is how long it takes."
In the meantime, Wood believes "there's still the risk of a euro quake that forces Europeans over this hump", which could hit risk assets (weaker stocks, commodities and euro) and force China, India and the ECB to ease and Federal Reserve to start QE3 (when dollar rises). To monitor this risk, Wood said to watch not only Italian government bond yields and its 5, 10-year yield spreads to German bunds, but also the French-German bund yield spread, which recently hit a new euro-era high. I transcribed more of what he said.
"Whether it's Italy going wrong or in due course France, that day is arriving. And the longer they take to resolve the issue the more it will cost and the more stress there will be in the interim. Clearly if the Italians get some austerity, if you get a new technocratic government, that might buy you 2-3 months of relative peace. But, I think that's the best case. Apart from looking at Italy, people also should be aware that the French bond yield over the German bund is now at euro-era highs. So I think that's as much an important variable to monitor..."
10-year French-German Spread (Bloomberg.com)
Chris Wood's thoughts on how markets would react to a "euro quake".
"From an Asian standpoint the "euro quake" risk remains a downside risk for all Asian equities. My formal recommendation since March of last year is for equity investors in Asia that want to hedge that risk remain short/underweight European banks. That remains a recommended strategy because European banks remain the epicenter of systemic risk. I think worse case a euro quake can send us down -- to equivalent lows in valuation we saw in late 2008 early 2009. But the good news for Asia, any kind of Euro convulsion will trigger more dramatic easing in Asia. And the good news to remember in such a sell-off is that both China and India have significant room to ease policy should they wish to. *In my view a euro quake is most likely to be accompanied by a stronger dollar, weaker euro and weaker commodity prices. All of which will give you more room to ease."
Wood on the Federal Reserve, ECB and QE3 in response to a "euro quake".
"Mr. Bernanke and the people around him have indicated their willingness to do QE3 sooner or later, which I think they will. The fact is the situation in euro-zone is much more dramatic, much more systemic than in the U.S. So in a real euro convulsion where the Europeans cut rates, go to monetization; my base case would be that would cause the euro to weaken against the dollar. And in response to that dollar spike and euro-zone crisis you may well get QE3."
I'll also add there's a risk that France could get its credit rating downgraded as a result of the euro-area crisis. Actually, a few days ago S&P accidentally downgraded France's credit rating. For another view on the euro zone crisis, read Nouriel Roubini's blog post: Why Italy’s Days in the Eurozone May Be Numbered.