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Risk assets have had a less shiny start today led by equities. Spain's Ibex and Italy's MIB index are leading European stocks lower, while the pan European EUROSTOXX 50 index is down more than 1%. This has taken the edge off the euro and the Aussie. EURUSD failed to break above resistance at 1.3080, while AUDUSD also withered above 1.0370.

The markets may have had a positive start to the year yesterday, but we were unconvinced, especially since Europe's peripheral bond markets were struggling as other asset classes managed to perform well. Today Spanish 10-year bond yields are up to 5.4%, up 30 basis points in 2 days. Today's move comes after a newspaper report said that Spain's new government is considering applying for loans from the European Union's rescue fund and the IMF to finance the restructuring of the country's financial industry. Unidentified officials were quoted in the piece, but there is no smoke without fire when it comes to the Eurozone sovereign debt crisis, and surely this suggests that the highest echelons of Spanish government are toying with the idea that a bailout might be the best route forward. The problem with this is that the current bailout fund - the EFSF - isn't big enough to deal with Spain's funding needs, especially if Italy was to follow suit.

The other thing spooking markets this morning is news out of Hungary. The Eastern European nation may fail to obtain fresh funds from the IMF after a series of bizarre actions by its government, which culminated with Friday's vote to limit the independence of the Hungarian central bank, which was passed although it was criticised by both the IMF and the ECB. EURHUF reached a record high above 315, and the Hungarian 10-year bond yield jumped above 10% in the past week. This is scaring investors since a bailout freeze, after Hungary requested an extra EUR 20bn at the end of November to protect against future funding difficulties, suggests that the country may be at risk of defaulting. Since Switzerland and other European countries hold a large proportion of Hungarian debt, including a US bond fund, a default would have a detrimental impact on the markets and today's rumours are denting sentiment.

Also rattling investors was news that Italian lender Unicredit - the largest single holder of Italian debt - was selling shares to try and boost its capital ratio as per the rules of the European Banking Authority. The sale is priced at EU 1.943 per share, below the EUR 5.91 that the shares trade on the Italian Bourse. Its share price tumbled on the news and was suspended at one point. This is what investors fear: their positions get diluted as banks try to raise capital throughout the first six months of this year. This could weigh on the financial sector and halt any rallies in European stocks in the near to medium-term.

So today we are back to worrying about the debt dynamics of Europe and economic data is taking a back seat, even though it has been fairly good in recent days. The final readings of December service sector PMI's were slightly better than expected. The French reading was revised up to 50.3 from 50.2, Germany's was revised down a touch to 52.4 from 52.7 while the composite PMI survey for the currency bloc was revised higher to 48.8 up from 48.3. This suggests that Europe may only experience a mild recession in the next few months and the economy may have troughed. Likewise, inflation pressures are also falling as the December inflation estimate fell to 2.8% from 3% in the currency bloc, which is good news for consumers in the currency bloc and justifies the ECB rate cuts at the end of last year.

The better tone to the economic data didn't help EURUSD, which failed at 1.3070, however it found support at 1.3023 and we could be in for some choppy range trading conditions in the next few days. The return of the jitters has helped the dollar regain some ground, although it doesn't look convincing above 79.80, which also supports range-trading conditions.

The minutes of the Federal Reserve meeting that were released yesterday, although they showed unease among several members about its plan to keep interest rates low into 2013, did keep the prospect of QE on the table if economic conditions deteriorated, which is likely to keep dollar gains capped for now. The Fed is worried about the Eurozone, and well it might be. The links between the US and European banking sectors keep the US economy exposed should the debt crisis over the water deteriorate any further.

EURGBP is stalling ahead of 0.8350 and we still think that a break of 0.83 to 0.8280 - the January 2011 low - is still possible. UK economic data was mixed today. The construction sector PMI was higher than expected at 53.2 vs. 52.3 in November, but money supply remains weak, falling 0.6% on the month in November. This keeps the spectre of more QE from the Bank of England in view as it suggests inflation pressures are non-existent, which could limit GBP gains in the medium-term.

US factory orders for November are expected to rebound by 2% in November; this data is released at 1500GMT/ 1000 ET. Germany and Portugal auction debt later this morning, which could keep the focus squarely on the currency bloc. The drop in Italian bond yields suggests that the ECB is actively in the secondary bond market today, which could ensure smooth bond sales.

Best Regards,

Kathleen Brooks| Research Director UK EMEA |

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