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European stock markets have taken their cue from the US and opened higher today. But the improved tone in risk may only be a consolidation phase and seems to be triggered by reports in the FT that European policy makers had finally agreed that banks need to be re-capitalised as soon as possible, and that it can't wait until the permanent rescue fund - the ESM - is in place in 2013.
· In the last two days the perilous situation faced by Europe's banks came into sharp relief. Dexia is to receive state-backed support and Deutsche Bank scrapped its profit target due to losses on Greek debt. The banking sector was leading the overall indices in Europe lower, so this news should be viewed as a positive for stocks since it shows EU finance ministers finally working together on an urgent problem. But there is a hitch. The size of the re-capitalisations necessary to buffer banks from the worst case scenario of a Greek default triggering contagion to Spain and Italy and possibly elsewhere could cost in the region of EUR800 billion to EUR 1 trillion, which is much larger than the numbers that have been bandied around so far. We don't know any details about how the EU fin mins plan to re-capitalise their banking sectors. We need to know the plans are: 1, big enough to cover the worst case scenario; 2, where the money will come from - e.g. France and Italy probably can't afford to bail out their banks without hurting their public finances; 3, when this will take place. Talk is cheap, without concrete details this plan is unlikely to sustain a long-term rally.
· Italy's credit rating was cut three notches by Moody's. The markets have shrugged this off as it brings Moody's in line with Standard & Poor's. However, it did put Italy's rating on negative watch, and without further budget consolidation or a stabilisation in Italian bond yields we could see further downgrades that have the potential to spook the markets. The ECB was reportedly buying Italian debt in the markets yesterday.
· Interestingly, stocks are higher this morning but this hasn't put downward pressure on Italian and Spanish bond yields so far today... If Spain and Italy continue to see their bond yields rise it's hard to see risk sustaining a rally.
· Data out today will help to gauge whether the service sector in Europe is in as much trouble as the manufacturing sector. The US ISM non-manufacturing index is also key to determining the strength of the all-important services sector. ADP private sector payrolls are also released, the market expects 73k, after 91k last month. The ADP report may be the prelude to NFP on Friday, but the relationship between the two is tenuous at best.
· The euro has stepped up a gear and it seems like we may be in a 1.3250- 1.3350/60 range. 1.3355 is a key Fib level resistance.
· The dollar is also in consolidation mode and has fallen during the European session. The dollar is moving in line with sentiment and brushed off comments from Fed chairman Bernanke yesterday that there are no plans for QE3 in the near-term.
· GBPUSD is lagging the euro today. There is a lot of data out of the UK so investors may sit on the side lines until then. We need to get below 1.5350 - the December lows the pound bounced off last month -for the downtrend to remain entrenched.
· EURGBP: this pair is key to determine the battle of the ugliest. Right now it is trading in no-man's land. Key levels include 0.8780 on the upside and 0.8540 on the downside.
· S&P 500- we could be in a correction phase as risk appetite improves. We may see a pull back to the 1,440 level - Fib resistance. However, we think that at this stage the markets may well use periods of strength to extend further short positions.
Kathleen Brooks| Research Director UK EMEA | FOREX.com
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