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Spain was in focus this morning after rating agency Standard & Poor's downgraded 11 of Spain's largest banks, which comes only a few days after the agency cut Spain's sovereign rating to BBB+ with a negative outlook. The bank/ sovereign feedback loop is getting more and more toxic for Spain. Like Ireland, bad bank debts seem to lead back to the government, while Spanish banks see their capital bases eroded when Spanish bonds weaken since they hold so much domestic sovereign debt. The only good news was that Spain's official GDP figures for Q1 were slightly less bad than expected. The economy contracted by 0.3% rather than the 0.4% that was forecast by the market (and announced by the Bank of Spain 2 weeks ago). It's difficult to know why there was an improvement as the bulk of the detail still hasn't been released. However, the underlying economic picture is still bleak for Spain: the unemployment rate surged to nearly 25% in Q1 and the economy is back in recession. Added to that rounds of austerity don't seem to be promoting growth.

Fiscal austerity vs. Eurozone growth

Spain has rallied against Europe's official austerity programme, the French election has hinged upon it and the Dutch government has collapsed because of fiscal targets. Yet reports at the weekend suggest that Germany is not going to back down and remains as committed as ever to austerity targets. The mixture of political change in the currency bloc, wrangling over the austerity vs. growth debate and Spanish downgrades hasn't been enough to throw the euro off course and considering the fundamental stress, it is looking fairly strong above 1.3220 - a former resistance level, now a key s/t support.

Why does the euro defy gravity?

So why has the euro been so resilient in the past month? Firstly, it is down to dollar weakness. The dollar has come under pressure as the US economic outlook has slipped slightly as economic data disappointments have mounted. The latest was GDP for Q1, which came in at 2.2% vs. 2.5% expected. Relative monetary policy has been a key driver of FX policy in recent weeks. While the Fed seems happy to allow Operation Twist to come to an end in June, it continues to sound concerned about the outlook for growth and keeps the QE card firmly in its back pocket. This, combined with a renewed bout of European sovereign stress is boosting in-flows to Treasuries, keeping yields lower and dollar strength subdued. This is most notable versus the yen, USDJPY is now close to 80.00, after giving back most of its March gains, however it has also weighed on the other dollar crosses.

In contrast, although the onus is on the ECB to continue to loosen monetary policy, it remains stubbornly concerned about inflation pressures, particularly those building up in Germany. We will hear more from the ECB when it meets this Thursday, no change is expected, and although the market believes there is a 30% chance of a rate cut. We think this is unlikely especially after the Eurozone's CPI estimate for April was higher than expected at 2.6%, above the 2.5% forecast, suggesting that inflation may not fall back to the ECB's target of 2% or just below any time soon. This could help keep the euro buoyed (or defying gravity) until we get more signs of economic weakness as we move through the second quarter. The Spanish debt auction on Thursday will also attract some attention and any sign that Spain is struggling to sell its debt could weigh heavily on the single currency.

Market moves:

So as we start a new week (and a new month) the same themes in FX are prevailing. The dollar remains weak, the euro continues to hold up fairly well and the pound is flying. EURGBP Is at its lowest level since mid-2010, and is close to key 0.81 support. We continue to think this pair will move lower, however it may be more of a grind lower than a surge lower, as the cross is starting to look oversold on a daily basis.

GBPUSD made another attempt to breach the 1.63 barrier earlier; however the dollar has started to claw back some losses mid-way through the London session. This pair is also starting to look overbought so we could be fairly sticky around 1.6260-1.6300. We get April PMI readings for the UK later this week. These are expected to fall slightly but remain in expansion territory. The construction survey will be watched closely because its 3% decline in Q1 was the largest contributing factor to the UK falling back into a technical recession. The pound will be sensitive to any upside or downside surprise in these surveys. An upside surprise could be the fuel necessary to propel the pound higher towards 1.6330 and beyond. A downside prize could see some weakness, although sterling remains fairly well supported by safe haven flows out of Europe and into its Gilt market which could protect the downside.

The Aussie is also in focus as the RBA meets overnight. It is expected to cut by 25bps to 4%. There is a slight chance it could be cut by 50bps, which would weigh heavily on the Aussie and we could see AUDUSD breach the 1.0360 daily sma support zone. A 25 bp cut without guidance of further cuts may only have a short-term negative impact on the Aussie. AUDUSD had a strong recovery in April, but the medium-term direction for this currency will depend on the RBA meeting, and it is definitely worth watching out for.

Best Regards,

Kathleen Brooks| Research Director UK EMEA |

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