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The big story of the morning comes from the Eurozone. The sharp drop in EURUSD below 1.2850 to a low of 1.2831 tells the story of the market today: fear has reached fever pitch with France, Spain and Italian lender Unicredit once again spooking the markets.

EURUSD has so far dropped 110 points, however the base of the daily Bollinger band at 1.2830 has held as support and in mid-morning the pair has been stuck in a tight range between 1.2830 and 1.2850. But we tend to think this will be a mere pause for breath before the single currency takes another leg lower.

There were a few catalysts to today's bout of risk aversion. The first was a report in the FT that Spain's banks would need to put aside an extra EUR 50bn of capital to cover rising bad loans. The new economy minister told the paper that banks need to clean up their balance sheets and shouldn't burden the Treasury - thus suggesting there will be no more government money going to Spain's beleaguered lenders on top of the EUR 20bn it has already spent helping out the banks. This has scuppered speculation that Madrid would set up a bad bank fund like Ireland did. Perhaps this is a shrewd move since Ireland's bailing out of the banks caused the government itself to seek a bailout.

Understandably this has caused Spanish financials to sell off now that they don't have Madrid to act as a back-stop if they get into difficulties. The minister said the extra EUR 50bn of provisions could be accumulated over a number of years. He also announced plans for stricter budgetary controls over the autonomous regions in Spain that have run into financial difficulties with the collapse of the property bubble.

Italian lender Unicredit saw its shares suspended for a second day and the losses in the stock are now more than 20% since the start of the year since Italy's largest bank said it was issuing new shares at a huge discount. This has put investors' noses out of joint, but it could have much larger implications for the markets. Banks across Europe need to raise billions in capital this year, they have been told not to reign in lending so the only option is to launch share issues if no sovereign-wealth-fund sugar daddies show up. However, to attract interest new shares need to be cheap, which causes a wave of selling as we have seen with Unicredit. Europe's banks' share prices have already taken a bettering, could capital raisings cause share prices to fall even more and some banks to fail? It's certainly a possibility and is a major risk for investors this year.

Sovereign fears are never far away either. The third event weighing on the markets was the French bond auction earlier this morning. This was waited for with trepidation as France aimed to issue 2021, 2023, 2035 and 2041 bonds. Yields were higher compared to an auction at the start of December and demand was lower, which does not bode well for France whose long-term debt burden is heavily front-loaded so Paris has to issue nearly EUR 300bn of debt this year alone. Added to that it has the threat of a credit rating downgrade hanging over it.

Greece is never far from the market's mind. The Washington Post reported that PM Papademos said that Greece could default on its debts and even exit the currency bloc if it can't deliver on promised economic reforms in the next few weeks. The Troika will visit Greece on January 16th and the private sector involvement (aka haircuts) on Greek debt is set to be decided by the end of this month. Private sector involvement is critical for Greece to get it future bailout payments. It can't afford not to as the first of some very large 2012 bond redemptions come due at the end of March. Added to that the Greeks go to the polls in April and could vote out the current technocratic government. So event risks abound, which may keep things volatile through the first half of this year.

Hungary is turning into the Greece of Eastern Europe. Its borrowing costs have jumped across the curve, and 3-year debt is currently yielding nearly as much as 10-year bonds at 10.65% vs. 10.93% for the 10-year. This is a worrying situation, especially since Hungary held a debt auction today and could only attract buyers for HUF 35bn, vs. the HUF 45bn planned. This highlights the negative sentiment towards Hungary and its government after it annoyed the IMF and EU by taking powers away from the central bank last week. This was NOT a good move, since they are its creditors.

This is likely to keep downward pressure on the HUF, which reached record lows vs.  the euro yesterday. Hungary's minister in charge of talks with the IMF/ EU is in a tight spot right now, however he said today that Hungary needs an IMF deal to secure immediate financing. But recent moves by the government could make these negotiations particularly tense. If the IMF refuses to lend more to Hungary then we could get our first default of the year....

Uncertainty abounds as we start the New Year. It is likely that volatility will persist as further bond auctions are scheduled for Spain and Italy next week. The ECB is rumoured to be buying bonds - someone has to...

The onus is on the US to lift the mood in the markets. The ADP labour market report (a prelude to Friday's payrolls) is due at 1315GMT/0815 ET. It is expected to show a 178k increase in jobs for the private sector after December's 206k increase. However, in this environment the US is playing second fiddle to the Eurozone, so a number around consensus could be brushed aside by the markets. Right now US futures point to a lower open as they follow the lead from Europe.

The UK may have had a better than expected Services sector PMI for December but the pound is dominated by risk appetite. GBPUSD is lower as the dollar gains safe haven bids, while EURGBP is testing support at 0.8250 after reaching 11-year lows.

Watch out for intervention risk from the BOJ. Japanese officials have been on the airwaves this morning saying that they are watching yen moves closely. This comes after EURJPY fell to its lowest level in more than 11 years below 99.00. 98.56 has been the low today and if we see any sharp drops this could spark the Japanese authorities to forcibly take action to weaken the yen.

Best Regards,

Kathleen Brooks| Research Director UK EMEA |

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