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The bond market is leading sentiment in financial markets today and its pretty ugly out there. Italian 10-year bond yields were up more than 40 basis points at one stage, although they have come off from their highs from 6.79% on rumours of bond-buying from the ECB.

This has weighed on the euro, and EURUSD is testing 1.3250 support. The euro is looking very weak within its 12-month range and at these levels then the 1.3150 lows from early October come back into view ahead of the all-important 1.30. In recent months 1.30 has been respected, however confirmation that the ECB will not help to reduce pressure on sovereign bond markets could change the tone of investors towards the single currency. The risk is that Italy, who has to auction more than EUR 110 billion in the first quarter of next year has a failed bond auction forcing it into accepting a bailout.

This is worrying for investors since there are no immediate funding sources available to cover Italy's debts for the next 3-years. The EFSF is still a mere EUR 440bn in size, and the ECB loan to the IMF of EUR 200bn is unlikely to be enough to cover Italy and Spain if things deteriorate. The ESM - the longer-term bailout fund that is due to take over from the EFSF - may be brought forward to July 2012 from 2013, but it comes with its own problems. A German official today said there were no plans for the ESM in the German budget. Since Germany is likely to be the largest investor in the EUR 500bn fund this is worrying.

Not even the news that haircuts for private sector holders of Greek debt is a one off and won't be applied across the board is enough to placate bond investors. Maybe it's because markets are finding it hard to price in the prospect of politicians keeping their word...

While peripheral Europe gets sold off Bunds and Gilts are attracting safe haven flow. 10-year Gilt yields have fallen 5 basis points today and this has helped the pound to recover from an earlier sell off. This is especially true for EURGBP. It is below key support at 0.85000 and is trading at its lowest level since March. The next support is now January's low of 0.83. So it seems like the euro may end the year where it started it; no better, no worse.

The bullish tone to the markets has disappeared at the start of one of the last full trading weeks of the year. However, sentiment is likely to remain volatile for the time being as volumes remain slim as we head to the Christmas holiday. However, economic data releases from Europe this week could also drain market sentiment as it looks increasingly likely that the fiscal union/ austerity route that Europe's leaders have chosen to take is likely to weigh on growth in the medium-term.

The FOMC comes back into focus tomorrow. We don't expect any change in policy. Although there is still a risk that the unemployment rate will rise and as external pressures remain high the Fed is likely to keep QE3 on the table, which could keep a lid on dollar strength this week. However, right now the dollar and other safe havens are in the ascendency.

Best Regards,

Kathleen Brooks| Research Director UK EMEA |

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