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The markets continue to reject the outcome of last week's EU maker-or-break summit. The ratings agencies are out in force. Yesterday they soured the mood for the euro bulls after they hinted that downgrades are to come as the summit failed to solve the problems faced by the currency bloc. Then last night Moody's placed several Spanish banks on review for a downgrade. The agency said that the banks face the dual risk of rising levels of bad real estate loans and also a weakening domestic economy.

The rating agency said that Spanish lenders will find it hard to boost their capital ratio after the European Banking Authority said they need to raise in excess of EUR 20bn by June next year. Due to the umbilical link between sovereigns and banks, if banks can't raise capital from private sources this puts the onus on the state to provide funds. Spanish public debt dynamics are already weak so added pressure to fund banks could weigh on sovereign debt, which in turn hurts banks because they hold so much national paper...

Also, since last week's summit failed to boost funds for the EFSF there is unlikely to be enough money in the pot to sort out the banks and the sovereigns at the same time. Essentially Merkel and co. have failed to deal with the immediate problems and instead are trying to prevent another debt crisis from happening. That's a bit like drawing up plans for a fire-proof house at the same time as your homestead is burning.

EU President Von Rompuy and EU Commissioner Barrosso are holding a debate on the EU Summit in the EU Parliament today and tomorrow the German Chancellor is addressing the Bundestag on the fiscal compact. Von Rompuy said today that the ESM should be ratified by miud-2012 (here's hoping as the EFSF is unlikely to last long if Italy gets into trouble), however he added a warning note that the new fiscal compact will not be legally easy to implement after the UK used its veto against the compact.

The ECB is practicing what it preaches and only bought EUR 635mn of European sovereign debt last week. However, there are rumours that it is back in the market today purchasing Italian debt and 10-year yields have fallen from their highs this morning. So the ECB is adopting a piecemeal approach to fighting this crisis rather than the big bazooka so many are calling for. 

As European bonds come under more pressure the EFSF is set to auction EUR 2 billion of 3-month debt at 1100GMT/ 0600 ET. All eyes will be on the yield investors charge to hold this debt. If the rating agencies do cut the credit ratings for Europe's triple A -rated states then the EFSF's top credit rating is also under threat. Thus investors that are only interested in top-rated securities could keep away from this auction as expectations of downgrades build.

Interestingly, French President Sarkozy, who faces a Presidential election next year, sounded particularly sanguine about the prospect of France being downgraded by two notches to AA in the coming weeks and months, essentially saying that France would get over it. 

Economic data is also in force today. UK CPI for November moderated to 4.8% YoY from 5% in October, as expected. Inflation is expected to fall sharply in January as the effects of the VAT hike fall out of the index. The pound is fairly stable after the release and after comments from BOE member Dale who said there was scope for the bank to do more QE.

The German ZEW survey is released at 1000 GMT. It is expected to decline further. The expectations index is extremely weak and may sink back towards the 2008 lows of -63.9 in the coming months. The current conditions survey is also falling but is nowhere near the lows reached in the last recession. However, German investors continue to believe that the outlook for the future is bleak which is likely to weigh on confidence and could keep economic activity subdued for some time.

So investors have to digest a triple whammy of bad news for Europe: 1, a failure to provide prompt action from the politicians 2, the threat of sovereign and bank downgrades and 3, weak growth. This is weighing heavily on the euro, which is close to the early October lows versus the dollar and is currently trading around 1.3160. Below here opens the way to a breach of the key 1.30 level, which could reflect a major deterioration in the sovereign debt crisis. EURGBP is also comfortably below 0.85 as the pound seems to be de-coupling from the euro. But for now this cross has found some support at 0.8450.

The dollar is higher again, and this is weighing on commodities including gold. The greenback is likely to be in demand as long as fears remain about Europe. However, if the Fed keeps the prospect of QE3 on the table then dollar gains could be limited as investors only choose the dollar for refuge. As we approach 1.30 the EURUSD is getting interesting. This level has been respected and has not been broached since January. If investors lose faith that the currency bloc can solve its debt crisis then we could see a sharp decline in the single currency over the coming weeks and months. Euro weakness could be especially acute against the yen - the ultimate safe haven. However, this also increases the chance of intervention from the Japanese authorities so it could be a choppy start to the New Year.

Stocks are understandably lower led by the banking sector. The Fed is likely to remain on hold today and its meeting could be fairly subdued as Europe continues to dominate.

Best Regards,

Kathleen Brooks| Research Director UK EMEA |

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