Smith is racing against time as Middlesbrough have also made a move for the versatile Watson, who is surprisingly being sold by Ruud Gullit to raise funds.
While Everton are the only side to have come up with the price Newcastle want, Smith has now been told by his chairman, Peter Johnson, to fund the deal by selling first.
Smith is therefore trying to move out sell the centre-half Carl Tiler back to Sheffield United for pounds 750,000 and to revive a double deal to take Craig Short and Mitch Ward to Nottingham Forest for pounds 2.5m.
Watson's future will be decided on Friday, when Newcastle return from European duty against Partizan Belgrade.
Nottingham Forest's French full-back, Thierry Bonalair, has returned to Paris for treatment on an Achilles tendon tear suffered last week, almost a year to the day that a heel injury cost him 15 games last season.
Forest's manager, Dave Bassett, said: "We are not sure how serious Thierry's injury is."
Joe Royle will be out of Manchester City's dug-out until Christmas, as he is to have a hip replacement operation.
Royle, the City manager, takes his side to Millwall for a Second Division fixture tonight but is then booked into hospital for surgery later this week. He will hand over the day-to-day running of the club to his assistant, Willie Donachie.
Royle still plans to oversee the club during his rehabilitation as they strive for promotion, but he will not be taking an active role for some time. The Maine Road manager said: "I will be in hospital for up to 10 days and then there is a similar recovery period after that.
"I will be able to go into the club a day at a time following the operation and then I'll be back to normal. But I will be in touch will Willie as often as possible."
Royle hoped he could delay surgery until the end of the season, but the pain has increased and the problem - common among former players - now needs to be dealt with.Reuse content