MORNING BID EUROPE-Merkel in decline

* A look at the day ahead from European Economics and Politics Editor Mark John and EMEA markets editor Mike Dolan. The views expressed are their own.

LONDON, June 19 (Reuters) - Tail wagging the dog? The fact that Bavaria's small CSU party can set Angela Merkel a deadline of two weeks to revamp Europe's migration rules or risk the breakdown of her coalition in Berlin speaks volumes about her declining stature. She (Munich: SOQ.MU - news) may yet be able to pull something out of the bag at the EU's June 28/29 summit by persuading other European capitals to offer her some kind of lifeline; and it is also not clear that the CSU itself would ultimately risk sliding into irrelevance by quitting her government. But increasingly, the leader who was once Europe's most powerful is starting to look very boxed in.

Which explains in part why the Franco-German summit outside Berlin today will not be a landmark in European diplomacy. She and Emmanuel Macron will agree a few modest reforms of the eurozone which they will then take jointly to the EU summit, but they will be dramatically short of the grand vision for rebuilding Europe on which Macron campaigned. Beyond Merkel's domestic troubles, the problem is deeper: Macron thinks big and strategic on Europe; the German chancellor remains cautious and above all fearful of upsetting her taxpayers. This all matters because the work needed to shore up eurozone structures in the event of a new financial crisis remains incomplete.

British PM Theresa May now has something under 36 hours to dig out a compromise with her pro-EU rebel lawmakers on what form of control parliament should have over the Brexit process. Last night's vote in the upper house showed an increased majority there for an arrangement that would give substantial sway to parliamentarians who on the whole want to avoid hard Brexit: that could embolden them to stick out for a deal favourable them ahead of tomorrow's crucial lower house vote.

MARKETS AT 0655 GMT

World markets are finally paying heed to the threat of a tit-for-tat trade war between Washington and Beijing, the damage it could inflict on global business confidence and huge pressure it will bring to bear on developing economies and emerging markets. MSCI’s main emerging market equity index dropped almost two percent to its lowest levels of the year, while Shanghai’s main stock index recorded its biggest one-day drop in more than two years. U.S. President Trump’s overnight attempt to up the ante in the increasingly bellicose trade row with China saw him threaten 10 percent tariffs on another $200 billion of Chinese imports in response to Beijing’s retaliation to match the first U.S. salvo of 25 percent tariffs on $50 billion worth of goods. The prospect of this unpredictable if slightly inane back and forth now risks eating into economic confidence everywhere. Even (Taiwan OTC: 6436.TWO - news) though Wall St’s moves on Monday remained fairly contained, S&P500 futures have dropped more than 1 percent since the latest Trump broadside. As Shanghai and Hong Kong returned from Monday’s holiday, the former’s benchmark bourse dropped a whopping 3.8 percent – its biggest drop since early 2016 - and HK lost more than 3 percent too. South Korea’s Kospi was down 1.5 percent. Japan’s Nikkei got an additional hit from a ‘safe haven’ surge in the yen, and lost 1.8 percent. European stock futures are marked down about 1.5 percent too.

The drag on U.S. and world growth was reflected in a drop in U.S. Treasury yields to their lowest in almost three weeks despite last week’s Federal Reserve interest rate rise, with the 2-10 year yield curve shrinking to below 36 basis points for the first time in almost 11 years. With Friday’s OPEC meeting and prospects of a production hike agreement in its sights, Brent crude oil prices fell back below $75 after some wild swings over the past two trading days. But the main action was in already pressured emerging market equities and currencies. Speculation that China will react to any rise in U.S. trade barriers by allowing the yuan to slide commensurate with the tariff rises saw the offshore yuan fall weaken against the dollar to its lowest since January and it’s now retreated almost percent since the peaks of March. The prospect of significant yuan depreciation – not least as the People’s Bank of China (HKSE: 3988-OL.HK - news) has not yet followed last week’s Fed interest rate hike – is likely to add even more heat to already battered emerging currencies. The latest in the firing line this week has been South Africa’s rand, which has fallen steeply to its lowest levels of the year amid the rising trade tensions and domestic concerns over strikes at power utility Eskom.

In Europe later, the big set piece of the day will be in Portugal at the European Central Bank’s annual forum in Sintra – where ECB chief Draghi and other top ECB officials will be speaking after last week’s decision to flag the end its asset purchase scheme later this year. * Europe corp events: Ashtead, Colruyt (EUREX: 11884447.EX - news) , Ferguson

* ECB chief Draghi, ECB chief economist Praet, Irish central bank chief Lane and St Louis Fed chief Bullard all speak at ECB forum in Sintra, Portugal; Bank of Finland chief Liikanen speaks in Helsinki, ECB supervisor Hakkarainen speaks in Frankfurt; Slovak central bank chief Makuch speaks in Bratislava

* Germany auctions 2-year schatz

* EZ April current account

* Hungary, Morocco, Botswana central banks policy decisions

* Government debt managers from Italy, Spain, Germany, Portugal, UK speak at Euromoney conference in London

* Sweden May jobless

* Poland May industrial output

* Irish finance ministry publishes Summer economic statement

* US May housing starts/permits (Editing by Andrew Heavens)