Following a sharp drop in the value of the EUR in Asian hours, there has been some evidence of short covering this morning. EUR/USD is trading off its overnight low, 'risk' currencies such as the AUD and the CAD have pulled back some ground vs the USD and European stock indices have edged higher. That said, sentiment remains very nervous and the EUR is still close to its 4 year low.

In spite of the huge EU/IMF 750 bln Monetary Fund announced last weekend and a new round of harsh austerity measures announced by Spain and Portugal, the EUR continued its slide last week. This bodes the question as to what more can be done to re-instate confidence in EMU and the EUR. This week has started with the news that the German government will press other Eurozone countries to adopt follow its example in setting rules for balancing budget within its regions. However, this is unlikely to fundamentally alter sentiment with respect to the EUR given broad based scepticism about the ability of Greece to stomach the budget reform already on the table. EU officials will be carefully watching the pace of the EUR's losses. The EUR is currently still above its long-term average of EUR 1.18 and can still be described as a strong currency. However, any signs that the EUR's falls are becoming unruly would intensify the concerns of EU officials. It is still possible that Greece may be forced temporarily out of the EMU if this can buy a more stable future for the core nations. For now the medium-term bias of EUR/USD is still lower.

The continuing Greece fiscal crisis has clearly intensified concerns about the prospects of sovereign default across a wide array of countries. The recent gains in Libor rates, gold prices and the VIX index are evidence of this. In this environment the USD is likely to remain well bid across the board. Cable is struggling in this environment; a low of USD1.4282 was printed before short-covering kicked in. While EUR/GBP is trading above last week's lows, it retains it bias lower in the daily charts and further evidence that the UK government is preparing to aggressively tackle the budget deficit in its June 22 budget will likely add to sterling's recovery prospects vs the EUR. The speech this morning by UK Chancellor Osbourne spoke forcefully about the pressing need for deficit reduction suggesting that EUR/GBP is still likely on course for a move to the 2009 low of 0.8400 and potentially below. The UK CBI industrial trends survey will be released later in the morning. Most recent data have showed a firming of conditions in the UK production sector. That said, the likelihood that the pace of economic expansion in the Eurozone will remain moderate this year and expectations of a tightening of domestic fiscal conditions may weigh on production in the UK.

AUD/USD is trading off its overnight lows this morning on the back of a round of short-covering. Although the AUD will likely struggle to make fresh headway vs the USD in the coming weeks in view of safe haven flows, the AUD is likely to be rewarded for Australia's well managed budget position (government plans to return it to surplus by 2012/13). This suggests there may be room for further gains in AUD/EUR. Tomorrow the market will see the release of the minutes of the RBA's May board meeting.

US Empire manufacturing and TIC data are due today. Jane Foley Research Director +44 207 398 5024