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The Spanish government’s press conference at approx. 1300 BST will lay out the details of the 2013 budget. This is a key event risk for the market as it could be the precursor to Spain applying for a bailout. Here are a few things to look out for:

1, Whether or not Rajoy formally announces that Spain will either apply for a bailout or a line of credit that comes with enhanced “conditions”. We doubt this will happen as it could ignite even more social tension after two nights of protests in Madrid.

2, What he may say instead is that the government has worked with the EU on a raft of economic reforms including labour market reform, social security reform etc. This could be Rajoy’s way of announcing a bailout by the back door. The ECB won’t buy Spain’s bonds unless it is involved in a reform programme created by the IMF and EU. But the ECB may be willing to limit conditionality (especially extra austerity) in return for a reform programme brought in over a number of years. If Rajoy can stage manage this Budget and show to the world and his own populace that he called the shots on conditionality and Spain will now be able to get financial support at a limited economic cost then he is a genius. The markets may buy it, the protestors in Madrid probably won’t.

3, Watch out for the reform package to see if it is social gunpowder. Freezing public sector pay, a reduction in pensions and a decline in unemployment benefits could go some way to making another EU39bn of cuts next year in order for Spain to meet its 4.5% fiscal target, but it may also cause another round of violent protests, which could dampen market sentiment.

4, We know that Spain’s budget deficit rose to over 4% of GDP by July of this year, which suggests that the 2012 deficit target will be missed. It is worth watching to see if Rajoy announces any measures to get the deficit back on track for the rest of 2012. This would require austerity and we don’t think the government has the stomach to announce fresh cuts when the build-up to this Budget has been so inflammatory. He will probably stick to 2013 plans at the press conference.

However, if Rajoy doesn’t address the problem of fiscal slippage then it’s hard to see how Spain can meet its 4.5% target for next year without more harsh austerity measures. It’s unlikely that the EU authorities will widen the target for Madrid, so this Budget may end up being null and void based on unrealistic assumptions like growth rates and miss-able fiscal targets.

The potential market reaction:

Any sign that Spain has been in touch with the EU to agree an economic reform package could be seen as a green light for the activation of the ECB’s OMT programme. This is what the markets want to see, as without this the ECB cannot be the “lender of last resort” for Spain. This means that a Budget that includes lots of spending cuts and glorious sounding reforms (however unlikely they are to work) could be well-accepted by the market and we could see a short term boost in the euro and other risky assets.

EURUSD has bounced off support at 1.2850 today, and may test the recent 1.29 high then towards 1.2950 in the short term. Longer term, the official activation of the OMT may see a more sustained rally in the euro, although we think sellers may come in around 1.3150-70, the double top from earlier this month.

EURUSD: hourly chart


Best Regards,

Kathleen Brooks| Research Director UK EMEA |

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