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After yesterday's risk rally the markets have turned around today. Maybe it is Friday 13th spooking the market, but the more probable reason is Spain and its banks. The ECB announced that Spanish banks had borrowed EUR 227.6bn in March, a huge jump from the EUR 152.4bn in February.

This is a massive red flag: Spain's troubled banking sector is addicted to the European Central Bank's heroin (aka cheap money in the form of LTRO loans). Without the ECB the Spanish banking sector would have to be nationalised to prevent it from collapse, yet due to the septic feedback loop between banks and sovereigns saving the banks would probably cause Spain's government to need a bailout. Thus the ECB is the only thing between Spain and bailout territory.

The Spanish conundrum

The markets don't seem to know how to react to Spain, hence the volatility and topsy-turvy price action we have seen this week. Does Spain need growth or austerity? Does it matter if Spain misses its fiscal forecast if it helps to reduce the unemployment rate? The concept of Spain, the fourth largest economy in the currency bloc, requiring a bailout is a lot to digest in one go. Big, developed economies like Spain are not meant to be bailed out, thus as the Spanish crisis unfolds it requires a new way of thinking from the market, one that dismisses the myth that the West is a haven of stability and prosperity.

This is weighing heavily on peripheral stocks, the Eurostoxx banking sector has fallen 15% since the middle of March as Spanish concerns have flared up once more. If this trend continues then we could be back at the lows last seen in November when Spanish bond yields were above 6.5%. Stocks are taking their lead from Europe's peripheral bond markets. 10-year Spanish bond yields are above 5.9%, which keeps 7% in view - the level deemed to lead to a bailout. Although bond yields retreated on Thursday, the move was fairly paltry, which made a move back towards 6% possible.

The ECB to the rescue?

So what will happen to Spain? International demand for its debt has dried up and its banks are hardly a reliable source of demand especially as bad loan rates (already at 8%) rare expected to rise this year and sovereign concerns deepen. Spain's banks are hit not only by deteriorating economic conditions but because they hold so much sovereign debt that rising bond yields also boost their funding requirements. Thus, we expect more LTRO auctions from the ECB to sort out Europe's future funding crisis. However, the next round of ECB action cannot just deal with banks' liquidity problems; it needs to feed the banks liquidity at the same time as re-starting its sovereign bond-buying programme the SMP. This is what the European authorities should do; there is no guarantee that they will. There is stiff opposition from the Bundesbank against allowing the ECB to buy sovereign debt and pump more cheap money into the economy, especially as German inflation pressures are rising. Added to that French Presidential elections take place over the next month, which could delay any decision on providing the weak periphery with more support. Sarkozy is unlikely to want to commit more of French taxpayers' money to bailing out its Eurozone peers when trying to win another term as President. Thus politics could once again impact this crisis causing volatility in the financial markets.

Don't expect too much easing from China

Hence the sell-off in stocks today is a sign of investor fears over the European situation and growing signs that the US economic recovery is not as strong as most people thought. China's growth rate slowed from 9.2% in Q4 2011 to 8.1% in the first quarter of this year. This was sharper than expected, however the markets have been well-prepared for a slowdown in China's huge economy. This is what Beijing has wanted, thus we don't necessarily think the GDP data signals potential policy easing in China in the near-term. The authorities are concerned about inflation pressures which rose to 3.6% in March from 3.2% in February. We believe that inflation not growth will drive policy this year.

Inflation is also a major concern for the Bank of England. It expects prices to fall sharply this year; however price pressures are still strong in the UK. PPI data for March was released earlier and it showed that input and output prices rose faster than expected last month at 1.9% and 0.6% respectively. Although inflation is coming down, it may not come down as fast as the BOE expects. We will hear more from the BOE next week when it releases the minutes from its last meeting.

Market moves:

Stocks have given back most of their gains from the last two days this morning as risk gets taken off the table before the weekend. As we mentioned at the top - the markets don't really know how to cope with Spain. Thus as we head into the weekend we are fairly directionless. Markets are oscillating between risk on and risk off in the short-term which can make trading a bit of a rollercoaster. There is no real conviction as markets expect central banks to come in and smooth the situation in Europe and stem any deterioration in the US growth picture.

So the markets wait for the next shot of morphine. In the meantime the 1.3050-1.3210 range in EURUSD persists. GBPUSD is more interesting. It has managed to remain resilient during the latest flare up in the debt crisis as it benefits from safe haven flows into the Gilt market. If it can break above 1.6060 that would be a significant move and could signal a leg higher for GBPUSD.

Gold is also one to watch. It has managed to rally in the last two weeks even though risky assets have sold off. Is it now a safe haven? We think not and rather the better performance of the gold price is down to 1, expectations of central bank action to sort out the Spanish crisis and 2, technical factors -gold rebounded strongly after pushing through $1,656 resistance earlier this month.

Best Regards,

Kathleen Brooks| Research Director UK EMEA |

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