EUR/USD consolidated close to the 1.2300 level through the initial part of the European session, pushing lower ahead of the US open. The optimistic response to yesterday's news from China has run dry with equity indices generally lower in Asian and in Europe this morning as the market absorbed the fact that any appreciation in the CNY this year vs the USD is likely to be moderate. In tune with this the AUD has lost grip of yesterday's rally edging back to the USD0.8750 area, USD/CAD has pushing higher towards1.0240.

Talk that Fitch sees the risk of a double dip in Europe has having become more likely has also weighed on sentiment. That said there has been better news in the Eurozone this morning. Germany's IFO index posted a better than expected reading in June of 101.8 (though the impact will have been offset by the fact that again the expectations index dropped, to 102.4) and improved news with respect to European sovereign budgets has begun to trickle through.

Yesterday's news that Greece's state budget deficit has dropped by 38.7% in the Jan-May period has been followed by a statement from the Finance Minister that Greek growth this year may be less slow than had been feared. This morning, the Spanish Finance Ministry confirmed that the Spanish central government budget deficit has also shrank in the first 5 mths of the year, Portugal stated that tax revenue was higher than forecast in this period and Germany indicated that its budget deficit may be smaller than previously forecast.

Later today, the Spanish government is due to vote on labour market reform. This will provide an imperative boost to Spain's competitiveness. That said labour market reform can take years to bear fruit and this will be no quick fix to the 20% unemployment rate. Theoretically labour market reform in Spain should help the cohesion of EMU, but it has come far too late to negate the argument that Spain will continue to struggle to compete with Germany under a common exchange rate over the next 10 or so years. Immediate gains for the EUR on the passage of this reform through parliament are therefore unlikely to be great.

Once again Spain has this morning being able to raise funds in the open market; selling a larger than expected amount of 3 and 6 mth bills. Yields, however, rose strongly relative to May reflecting the market's need for a risk premium on this paper. While today's auctions follow better than expected results in last week's Spanish bond auctions, scepticism that the ECB may have been a buyer has offset the positive implications for the EUR. Fears that Spain may still be facing further aggressive drops in asset prices and therefore further increases in non-performing loans continue to the cloud the outlook for the EUR.

UK Chancellor Osborne is due to start delivering the UK's most austere budget in a least a generation at 12:30 BST this afternoon. The market's are well primed for austerity, but pivotal for the outlook for sterling assets will be whether the economy can shoulder the burden without dipping back into recession and without widespread labour unrest.

Also if concern to the markets is whether the backbenchers within the LibDem coalition will swallow a budget which many see as being out of step with their core values. EUR/GBP remains essentially range bound ahead of the speech though sterling has given back its overnight gains. Cable is trading lower in tune with the weaker bias of EUR/USD.

Canadian CPI, US existing home sales and Richmond Fed Manufacturing index are due this afternoon.

Jane Foley

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