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The markets have clawed back some of yesterday's losses - stock have opened higher in Europe even in Spain, however the sovereign debt crisis still looks precarious and we would not be surprised if this morning's moves provided only brief respite.

Spain remains front and centre


The markets are taking their lead from Spanish yields. They rose to 6% yesterday, the highest level since November 2011, although they backed away from that level at the European open, yields have started rising again mid-way through the morning and unless we get some signal from the European authorities that they will support the sovereign debt markets it is unlikely that peripheral bonds will be able to stage much of a recovery.

The trigger to the latest round of sovereign fears was the Spanish Budget and the break above 5.5% in Spanish 10-year yields - the top of the recent range. Spain may not be the next Greece (its public debt levels are roughly half those in Greece) but its situation is definitely grave. The markets are concerned about growth and unemployment in Spain and the latest Budget looks like it will only aggravate growth concerns and will fail to deliver on fiscal targets set out by the EU. We got some more colour on the Budget yesterday when the government announced cuts to the education and health budgets. However, these departments are controlled by autonomous regional governments, thus it is hard for the central government to manage the cost-cutting process thus increasing their risk of failure.

Lack of clarity about Spain's situation


Investors are concerned about Spain for three reasons: 1, the fact Spain's growth outlook is likely to get worse before it gets better and 2, the fiscal consolidation process is likely to be much more complicated than the Budget forecasts suggest, so this lack of clarity is also fuelling the market dislike for Spanish government bond debt. 3, Spanish banks are also crippled under the weight of bad real estate and developer loans and there is still the chance that the central government will need to bail out the banks even more, thus aggravating the situation and pushing Spain closer to a bailout.

Bond yields may have backed away from 6% today, but Spanish debt still seems like a hard sell. We will get some indication of investor sentiment later today when Italy auctions 3 and 12-month debt at an auction at 1000BST/ 0900 GMT. If this auction is as badly received, as Spain's was last week, expect another lurch higher in peripheral bond yields and another flight to safety from investors.

Fed speakers could temper dollar rally


Spain may be dominating but there other things going on in the markets. Yesterday Fed speakers sounded a cautious note on the outlook for the economy, although non-voter Kocherlakota said that a lengthy exit strategy will be necessary but policy may need to be tightened later this year or next (before the Fed's current forecast of 2014). Late tonight Janet Yellen, the vice chair of the Board of Governors at the Fed (second in command to Bernanke), is talking in New York about the outlook for the economy and monetary policy. She is a noted dove so her words will be listened to closely.

There has also been lots of speculation about the Bank of Japan. It left policy on hold at its meeting that concluded yesterday, however today the Japanese press has reported that the Bank will increase its asset purchase programme at its meeting later this month, which should be yen negative. However, in an environment of heightened risk aversion the yen is likely to rally regardless of BOJ action. Likewise, the other safe haven, the swissie, continues to attract flows and the EURCHF floor at 1.20 is now at risk of being tested again. This level was breached last week but the SNB intervened in the markets to protect it. If the floor wasn't in place then we would expect a much lower EURCHF. In the absence of EURCHF as the ultimate sovereign risk trade, EURJPY has taken the mantle. It has tumbled from 111.00 to below 1.06.00 today. 105.90 a key support (200-day sma) after the cross fell below the top of the Ichimoku cloud at 106.20. This suggests the up-trend in EURJPY is now over and opens the way to test of 105.00.

Is the UK economy defying gravity?


The pound remains the strongest of the risky currencies, after falling to 1.5800 yesterday it bounced back and is currently above 1.59. The BRC retail sales data print was warmly received by the market after it said sales rose 1.3% compared to a year ago last month on the back of a pick-up in clothing and shoe sales it put down to the unseasonably warm weather. GBPUSD still looks range bound to me between 1.58 and 1.5950. However, I don't believe the pound will be able to make another stab at 1.60 vs. the dollar while sovereign fears remain at the forefront of investors' minds.

Market moves


Today the markets are consolidating after yesterday's rout, but EURUSD is still at risk of breaching the 1.30 level in our view, especially if Spanish bond yields take another surge higher or if the Italian bond auction disappoints. It's hard to see things calming down in the near to medium term unless EU authorities intervene in the coming days and weeks. Add to that election risks are rising as France and Greece go to the polls for key elections later this month. Eurozone fears look like they are here to stay, which could be a rocky time for risk assets.

Volatility has spiked to its highest level since early March (as measured by the Vix), if we see risk continue to sell off and volatility to spike even higher then there is a risk that central banks (especially the ECB) will intervene to smooth things out, but for now we haven't seen any sign that concrete intervention is on the horizon from the ECB.

Best Regards,

Kathleen Brooks| Research Director UK EMEA |

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