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The big event of the morning was the Spanish bond auction, however it failed to generate anything more than an immediate ripple in the FX market. The auction raised just below the top of its target amount of EU2.5bn, at EU 2.49bn. Although demand was strong, Madrid had to pay up to attract investors to its debt. The yield on the 2015 debt it sold jumped to 4.375% vs. 2.89% at an auction in April, the 2016 debt sold with a yield of 4.876% vs. 4.037% at an auction earlier this month.

Will Germany soften its stance?


In the aftermath, EURUSD is down about 20 pips but it remains above 1.27, while Spanish bond yields have actually fallen. The consolidation period in the market may continue as we lead up to the G8 summit in the US this Friday as there is some speculation that the European authorities will concentrate on growth and potentially consider amending the Fiscal Compact that could allow Greece to stay in the currency bloc.

The new French Finance Minister Pierre Moscovici said this morning that the G8 summit would concentrate on growth. He also said that France could not support the Fiscal Compact in its current form. So if we get some changes to the fiscal pact alongside some measures to boost growth in the weaker peripheral economies then we may get a squeeze higher in risky assets. In the past EU summits and soothing words from Angela Merkel and co. have been able to placate markets in the short-term during periods of sovereign stress. But it will require a major softening of the German stance towards austerity to sustain gains in risky assets, in our view. Without this then the markets are likely to remain jittery as we lead up to the second Greek election next month.

Greeks: anti austerity but pro euro


However, the outcome of the election is difficult for the markets to predict and price at this stage. The latest polls from Athens suggest that more than 80% of the Greek population want to remain in the Eurozone, yet Syrizia - the anti-bailout party - is currently on course to win the next election. So either 1, Germany softens its stance allowing the new Greek government to amend bailout terms or 2, the Greek people baulk at the prospect of returning to the drachma and actually vote for the pro-bailout parties at the ballot box. The first outcome is better in the long-term, although it seems quite unlikely, the second outcome could boost risk assets in the short-term as it kicks the can down the road and should help Athens avoid defaulting in July when it is scheduled to run out of money.

The Greeks have been preparing for an adverse conclusion to this problem for years, by moving their money out of Greek banks and into safer havens like Switzerland. According to the latest data from the Bank of Greece, EU5bn has been removed since the election result. This is a sharp increase in the pace of withdrawals, although Greek banks have seen approx. EU 5bn of deposit withdrawals per month since the Greek debt crisis first erupted in 2009. Thus, people were moving their money out of Greece before the prospect of a Grexit was considered likely. This leaves the banks 1, reliant on the ECB for funding and 2, unable to lend money to help re-start the economy.

The Grecourse shifts from elections to the banks


Greek banks have dominated the Grecourse (Greek discourse!) in recent days after it was announced yesterday that the ECB had stopped some Greek banks from accessing re-financing operations due to concerns about re-capitalisation. These banks will now need to get Emergency Liquidity Assistance from the Bank of Greece. This is not unusual, and Irish banks did the same thing in 2010. We would expect the second bailout funds ring-fenced for bank recapitalisation now to be released to allow Greek banks to go back to the ECB, as ELA funding is deemed temporary. However, with the torrent of cash running out of the Greek banking system the question now is whether the EU 30bn of bank funds is enough to stem the tide?

Going forward, the key thing for investors to watch is the European banking sector. The Bloomberg 500 bank and financial institution index has not shared in the recent consolidation phase, after giving back recent gains yesterday after the report about Greek banks and the ECB. It has continued to decline this morning, which leaves risky assets vulnerable in the short-term.

Central bank watch


The ECB isn't the only central bank to watch. Yesterday's Inflation Report suggests that the Bank of England remains dovish, even if member Adam Posen isn't voting for more QE. The bank left the door open to more liquidity support as it said it expects inflation to undershoot the target in two years' time and it was concerned about the Eurozone crisis. The Fed minutes also sounded a note of caution. It said the economy was expanding moderately, and it expected moderate job gains in the coming months. However, downside risks to growth came from Europe and tighter fiscal policy in the US, which warranted the FOMC maintaining its policy of keeping rates ultra-loose until 2014. Regarding QE the minutes said the Committee would continue to review the size and composition of its holdings and is prepared to adjust these holdings as appropriate to promote a stronger economic recovery. Thus the Fed could act again if necessary, although there are no immediate plans to do so. The dollar climbed on the back of the minutes and remains well supported. The spread between US and German and UK yields is also dollar positive, as concerns about the Eurozone imploding impact Gilts and Bunds more so than US Treasuries, which is also dollar positive.

Market moves:


European stock markets are down this morning, although the markets are much calmer than they were earlier this week. In EURUSD 1.2680 is good support ahead of 1.2624 - January's low. 1.2750 remains the level to bear. GBPUSD has sold off sharply post the Inflation Report yesterday. Below 1.5880 open the way to 1.5820 -the 100 and 200-day smas. The daily and hourly RSI's suggest momentum in cable remains on the downside.

Keep an eye on EURCHF. Stiff support comes in at 1.2000 - the SNB's floor. We believe the Swiss authorities will defend this level as the SNB has pledged its credibility on maintaining its peg and still views EURCHF as overvalued. But in this environment it is likely to remain under moderate downward pressure, but as we get closer to 1.2005 expect some sharp volatility and a pullback is possible to the 1.2020 zone.

Best Regards,

Kathleen Brooks| Research Director UK EMEA |

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