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The markets are in buoyant mood as we start the week. Stocks are higher for the second session in a row in Europe and EURUSD is testing 1.3350. While stocks and risky FX are higher, European bond markets are interesting to observe. German and Belgian bond yields are higher, while Italian and Spanish yields are lower, French yields are roughly neutral.

What does the bond market tell us? Firstly, those markets are expecting some form of bailout and action to be taken on Spain and Italy. However, stabilising the third and fourth largest economies in the currency bloc is a zero sum game - someone wins and someone has to lose. That person is Germany. Either way it loses, for example: 1, Eurobonds are introduced meaning that German debt costs converge (read rise) towards rates that its European counterparts pay. 2, The EFSF levers up and Germany is on the hook to pay for 20-30% of European bond guarantees.

So what about Belgium? It had its credit rating cut on Friday, it has no government and it only rushed through its 2012 budget this weekend. The markets have lost patience with political and fiscal nonchalance, so it should come as no surprise that Belgium is also coming under attack as it also has a debt to GDP ratio of just over 100%. However, its tiny economy means that Belgium is more of a symbolic problem (Brussels as centre of Europe) than practical problem.

The better tone to risk this morning was fuelled by reports in the weekend papers that France and Germany were working on a measure to instil fiscal rules that wouldn't require lengthy Treaty changes. This has the potential to open the way to greater intervention by the ECB in the form of more fervent bond purchases. Sentiment was also buoyed by expectations that the IMF was putting together a EUR 600 bn package of loans to bailout Italy. Although the IMF story has been denied by IMF officials, it hasn't dented market sentiment - no smoke without fire, hey?

The pound has been lagging overall risk appetite today. It could be down to month end rebalancing which is negative for the pound after the strong run in Gilts over the past month, but some domestic event risk could also be weighing on sterling. There is a lot of event risk for the UK this week: the largest general strike for years on Wednesday that could ground airports, schools and even hospitals. Added to that the Chancellor gives his autumn statement tomorrow, which is likely to be more gloomy news on the UK economy. However, the pound has played catch-up GBPUSD is back above short-term resistance at 1.5530, the next level to watch is 1.5550; however we think that it will be driven by overall market sentiment and is thus vulnerable to headline risk from the Eurozone, also due to domestic factors the pound could be a sell on rallies this week.

The banking sector in Europe is leading European markets higher today. This comes after reports of how banks are trying to plug their capital gaps. The FT reports that BNP Paribas is mulling a sale of its private equity business. Usually if banks are shrinking it should be bad for balance sheets, but these are strange times we live in so the more capital banks have to cover losses on their sovereign debt holdings, the more likely they are to be favoured by investors. But banks remain in a fragile state, reports this weekend said that banks' issuance of bonds this year is a mere two thirds of last year's level at just over $400bn. So liquidity fears remain at the forefront and banks are likely to have to dispose of plenty more assets, reducing their potential for growth over the coming years.

The next two weeks are critical for the Eurozone in our view: this week's Ecofin meeting will prepare the way for the December 9th EU Leaders summit. Combined with an ECB meeting on December 8th, the markets expect some major action to be taken to boost growth and help the struggling banking sector (rate cut) and sooth the markets (Eurobonds, EFSF expansion, IMF bailout plan etc.). One thing is for sure: the Eurozone is reaching boiling point and the decisions made in the next 2 weeks will determine the survival or collapse of the euro and the Eurozone project in the medium-term.

Best Regards,

Kathleen Brooks| Research Director UK EMEA |

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