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While everyone's focus was on Europe and the Standard & Poor's mass bank downgrade overnight, China slipped under the radar and cut its reserve requirement ratio by 50 basis points effective on Monday 5th December. This caused a bounce in risk assets and in the Aussie in particular.

We knew that China had been cutting the RRR for some regional banks and allowing them to lend more to small businesses, however today move is is a sign that Beijing has ended its tightening policy and is now more concerned about external threats to growth emanating from Europe than inflation.

Although rumours circulated that the PBOC had also cut interest rates along with the RRR cut, interest rates remain unchanged. RRR cuts are a less aggressive policy tool than interest rate cuts which are a more effective way to boost money supply in the economy. So the inflation/ growth problem is finely balanced in China at the moment, but today's move signals to us that China is concerned about events in Europe and does not to want to be accused of constricting growth when the external outlook is so uncertain. Beijing is now in wait and see mode and whether or not we get more loosening from the Chinese will depend on the outcome of the European sovereign debt crisis.

So Europe is still at the heart of things, although China has the power to disrupt market direction as we have seen today. Oil bounced on the news but soon reversed course. Brent crude is trading just above $110 per barrel, while copper has surged more than 0.5% on the news. Commodities tend to follow Chinese monetary policy closely since China is a major source of commodity demand worldwide. But although looser monetary conditions may go some way to protecting the Chinese economy in these uncertain times, and thus safe-guarding commodities' main source of demand, the cut in the RRR is in response to fears about the economic outlook. If things get worse then China may have to do more than just cut the RRR to ensure growth remains stable and demand for commodities doesn't fall off a cliff.

So this makes the next couple of weeks' events in Europe even more important. The first hurdle is today's Ecofin meeting in Brussels. The main point that came out of the Eurozone finance ministers' meeting yesterday was that there is consensus that the funds required to boost the EFSF may not be forthcoming and that it may not be up and running until next year (the original deadline had been mid-December). EFSF CEO Regling put it clearly that investors will only invest in the fund if it is a commercially viable product and that the leverage process will take some time. We will have to see if the EU's plan to guarantee bonds to the tune of 20-30% is considered commercial enough to lure cash-rich investors.

One thing is for sure, the bond markets continue to tell us that wealthier Eurozone nations are getting close to their tolerance level for helping weaker nations, hence talk of getting the IMF involved even if it means the ECB lending to the IMF who then distributes the money to distressed Eurozone nations. As we said before saving the Eurozone is a zero sum game: Germany et al lose while Italy et al get saved, hence the narrowing of spreads between Italian, Spanish and French 10-year bond yields and their German equivalent after they reached record highs in recent weeks. All eyes are now on the 9th December. Can Europe pull this one out of the bag? We have been disappointed before...

So what does all of this fundamental mumbo-jumbo and headline Ping-Pong mean for the markets? Prior to the China announcement stocks had opened slightly lower, but as we pointed out in an earlier note the banking sector in Europe had been able to hold onto gains, which should limit losses. This is what happened and stocks are higher today - given a big push by the China announcement.

Overall, we believe that choppy range trading conditions will persist in both FI, FX and equity markets until we hear from the EU leaders at next week's summit. As we have said before we are approaching some key levels in FX markets. 1.30 in EURUSD is a level the market has respected for the best part of a year. It seems unlikely that the markets will shoot through this level, as below 1.30 is a game-changer for the euro and could signal much deeper losses for the single currency. So expect stickiness in euro crosses from now on, although it continues to trade with a bearish bias.

We mentioned above that the ECB may be given more flexibility to buy Eurozone debt in the coming weeks. We need to find out exactly what this is, but ECB involvement is definitely critical to stabilising the situation. Interestingly enough the moment the ECB gets involved this could be the time that the euro weakens significantly, especially if the ECB embarks upon QE or unsterilized bond purchases. At this point we could see the euro de-couple from risk assets: as stocks recover on the back of ECB involvement the euro may come under sharp downward pressure.

It feels like we are reaching an endgame for this crisis - however, we have no details and we have been thwarted before. The next week is critical and will determine the direction of markets in the medium term.

Best Regards,

Kathleen Brooks| Research Director UK EMEA |

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