NEW YORK -- The fate of the year-end rally underway on Wall Street will hinge on whether Europe's top political leaders and bankers can restore investor confidence in the eurozone by outlining a credible plan to stem its debt crisis at a critical two-day summit that starts today in Brussels.
Investors have pushed the Dow Jones industrials up almost 1,000 points, or 8.6%, in the past eight trading sessions amid rising hopes that economic powers France and Germany can push through a plan that calls for more fiscal unity and budget discipline throughout Europe.
The hope is that if European governments can agree on a pact to get their financial houses in order, it will clear the way for the European Central Bank to take a more aggressive role in combating the crisis. Investors are hoping that the ECB, led by President Mario Draghi, will ramp up its purchases of government bonds in such places as Italy and Spain as a way to drive down borrowing costs to levels that would make it easier for nations to make interest payments and gain cheaper access to funds.
A lot is riding on what comes out of the European Union summit. The market's recent rally suggests expectations are high that Europe will make good on its promise to fix the problem.
Friday "could be the day that the Europeans start to win their battle to save" the eurozone, says market strategist Ed Yardeni of Yardeni Research.
While Yardeni says calling the summit "make or break" for the markets might be too much hype, he says it's important that Europe finally delivers a "grand plan rather than just another grand illusion."
A market-friendly outcome to the summit should boost investor confidence, spur risk-taking and lower the odds of a banking crisis in Europe that could drag down the global economy. Stock prices will likely head higher and yields on European sovereign debt are likely to fall, says Quincy Krosby, market strategist at Prudential Financial.
If the summit's goal of attacking the debt problem is deemed a failure, cash is likely to flee European bonds and the euro currency and flow to the U.S. dollar, which would be a sign of risk aversion, she adds. The ECB is also less likely to risk more of its capital in buying bonds of European countries when other investors are dumping them.
Pressure has been building on Europe to take the tough steps needed to avoid a banking crisis, halt financial contagion and restore investor confidence. Earlier this month, bond investors dumped their holdings of European government debt, driving up yields in key countries such as Italy above 7%, a level deemed unsustainable.
This week, a U.S.-based credit-rating agency put the debt of 15 EU countries, some of Europe's biggest banks and the EU itself on credit watch, a move that could result in lower ratings and higher borrowing costs. U.S. officials, including Treasury Secretary Timothy Geithner, now in Europe meeting with key summit participants, have also been stressing that Europe needs to act aggressively.
The risk, of course, is that Europe could come up with a plan that investors perceive as inadequate.
"There is always a chance of disappointment," says Krosby. How violently financial markets react, however, will depend in large part on the "level of disappointment."