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All eyes are on the ECB 's 3-year Long Term Refinancing Operation (LTRO), the first of its kind, which takes place at 1015GMT. The markets hear the word liquidity and tend to jump for joy; hence stocks have performed well this week. However as we get close to the main event risk assets are under a bit of pressure and EURUSD hasn't been able to sustain gains above 1.3150.

Because these are the first auctions of their kind from the ECB it's difficult to judge how they will go. Expectations for the amount of take-up include estimates ranging from EUR 300-500bn, however this is cheap money on offer from the ECB that banks may be eager to soak up. But the question for investors is what they will do with it?

Some believe that the LTRO operation is a cynical way to get around the ECB's no QE rule, instead of buying government debt outright it will lend to banks instead to get them to buy sovereign debt. Indeed, if you can access financing from the ECB at 1-2% and choose to invest that in 10-year in Italian debt, which yields approx. 6.5% then you would be in line for a nice real profit once adjusted for inflation. This seems like a no-brainer; surely it's an easy way to make money for the beleaguered banks thus the LTRO will spark a risk rally akin to QE2 in the US?

We are not so sure. The banks are in a bad way in Europe and there are many constraints on what they can own so the LTRO money may not seep into equity and commodity markets as easily as the Fed's dollars did. Also, banks have already seen their balance sheets ravaged by their holdings of sovereign debt and they have been trying to off-load these assets from their balance sheets in recent months, thus they may not be so keen to hold more of it. So where will this money go? Firstly, it will go to financing their hefty liabilities and then the ECB hopes it will go to lending domestically and trying to ward off a painful recession next year, although this is not guaranteed.

The ECB will argue that LTRO operations are not QE and it is not financing governments. However, although the ECB does sterilise its operations it has seen its balance sheet expand this year, and the ratio of Fed assets on its balance sheet to ECB assets has fallen since the summer as the ECB's balance sheet has expanded at a faster pace than the Fed's, who chose to keep its balance sheet static with Operation Twist.

What does this mean for the euro? In the long-term the expansion of the ECB's balance sheet should mean a weaker euro as the Bank floods the economy with money. However, in the short-term we could see some euro strength. After the Fed announced QE2 in November 2010 the dollar rallied 7% over the next 4-weeks, before declining sharply through to mid-2011. The euro could do the same especially if the Fed can keep its hands off the printing presses for the medium-term.

In the short-term EURUSD is making hard work of breaking above 1.3150 - but it continues to try and reach higher. We could be in for a range-trading day as the markets digest the results of the LTRO auctions. The market could react one of many ways to the auction: if the pick-up is not big enough (say less than EUR150bn) then we could see risk sell off as fears remain about the banks' access to funds, but if pick-up is too much then investors could also take fright as it may suggest that the banks' position is even worse than we first thought. So expect some sharp moves later today.

In the commodity sphere, Brent crude is running into resistance at $107.50, its 100-day sma, but $105 remains key support. Also, EURGBP is finding support at 0.8350; if it can sustain gains above here then we could see back to 0.8370 in the short-term. Elsewhere, AUDUSD hasn't been able to sustain gains above 1.02.

UK economic data today showed that the BOE voted unanimously to keep rates and QE levels on hold at its meeting earlier this month, while public sector borrowing, typically high in November, was weaker than expected at GBP 15.2bn, lower than the GBP 16.65bn estimated. This data had limited effects on the market, Gilt yields are steady and the pound is following overall risk sentiment and is coming off its highs versus the dollar and the euro.

Overall, risk is taking a breather today and stocks, commodities and FX are coming off their highs. Expect volatility and the prospect of very thin volumes later. A good LTRO auction could see risk resume its rise later this morning.

Best Regards,

Kathleen Brooks| Research Director UK EMEA |

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