The results of yesterday's 3 mth ECB fund allocation had the effect of soothing worries about the funding positions of European banks. Perhaps fears had been overdone, although until stress tests are published for the majority of banks it will be impossible to know for sure. Meanwhile there is plenty of evidence to suggest that there are tensions in the system. This morning the results of the ECB's money market operations show that 78 banks borrowed a hefty EUR 111.2 bln in 6 days loans.

Given that these loans were at 1% well above the level of Euribor, the obvious implication is that some banks are still very reliant on the ECB for funding. The ECB clearly wants to retract its emergency measures but fears that more liquidity will be drained are having an adverse impact on Euribor. 3 mth Eurobor this morning rose to 0.782%. This is the highest rate since Sept last year and this morning rise was the biggest daily gain since October 2008; when strains in the US banking sector were at their peak.

ECB money market operations are clearly being dominated this week by the fallout from the expiry of last year's 12 mth EUR 442 bln 1% loan. While conditions may settle down in the coming weeks there is sufficient evidence to suggest that the ECB will have to tread carefully in 'normalising' its emergency liquidity measures liquidity. The EUR strengthened in early London hours this morning with USD supply lifting EUR/USD back to 1.2300 but tension in the money market should be sufficient to underpin concerns about the stresses in the European banking sector and this suggests that the EUR is likely to stay on the defensive at least through the summer.

While USD supply at the open allowed EUR/USD to push higher, the overall tone of the market is defensive. Even though the results of Japan's Tankan survey brought moderately better news and German and Italian manufacturing PMI data this morning were a little better than expected, the fall in the Chinese PMI produced the bigger reaction in the market. Stocks are down across the board and the yen, while off its intraday highs vs both the USD and the EUR, is holding close to this week's strongest levels. On the back of this week's poor US consumer confidence number and disappointing indication from the ADP employment survey, investors are set to remain nervous ahead of tomorrow's key US payrolls number.

UK PMI manufacturing data this morning were in line with expectations, a little lower than the May release and produced little reaction in sterling. EUR/GBP is pushing higher in line with the better tone towards resistance at the 0.8275/8300 area, a break of which could trigger a leg higher. In contrast sterling is performing better vs the USD. Given that the immediate fallout from the budget has past, EUR/USD is likely to remain a dominating influence on the sterling crosses near-term.

The AUD found support overnight on news that the government is close to a deal with the mining companies over the previous PM's 40% tax. That said, the prospects for the AUD remain closely tied to overall appetite for risk in the market and to expectations regarding relative Chinese demand. Fears of slower growth in Chinese and uncertainty about the outcome of tomorrows US payrolls report are likely to limit the near-term potential for the AUD.

US ISM manufacturing, initial claims and pending homes sales are due this afternoon.

Jane Foley

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