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The markets aren't holding out too much hope for a neat resolution to the sovereign debt crisis at this week's EU summit. EURUSD has been stuck in a very tight range in the last couple of days, which is a warning sign for traders: the outcome of this summit will be a major break-out event, either one way or the other for the single currency.

The big question now is what will the EU summit deliver? At the very least it needs to deliver a roadmap towards 1, greater fiscal unity and the eventual mutualising of debt and 2, fiscal oversight and centralised budgets. There are already steps towards this, the EU will debate a proposal to create one finance ministry for the entire currency bloc, which seems like a good idea (after all, the Treasury works in the US and borrowing costs there are at a record low) but it is likely to face stiff resistance. The Bundesbank chief yesterday placed the blame with France for not wanting more centralised oversight in the Union, claiming that Paris was less willing than Germany to give up sovereignty. Added to that Germany itself is ramming home the need for more oversight before debt mutualisation but is not willing to accept half-baked centralisation plans. Germany's deputy finance minister already dismissed the reports on the creation of a centralised finance ministry, saying that the idea leans too much on mutual debt ideas and not enough on deficit control.

The North vs. the South and France somewhere in the middle

Thus, the scene is set for a political showdown: you have the northern bloc of financially strong nations pushing for a new Europe created along the lines of strict budgetary management, vs. the financially weaker states (in this group I include France) pushing for debt mutualisation and for Germany to essentially under-write the debt of the rest of the currency bloc. You can see where the sticking plaster comes unstuck: Germany is never going to agree to this without control on how money is spent, while the nations who want debt mutualisation are not willing to cede this control to Berlin, claiming that it interferes in their sovereign rights.

The can-kicking has already begun. A leak from the EU said that after this week's summit steps towards fiscal and banking union won't come until December with an interim report in October. No one realistically expects fiscal union to be created overnight, however, by widening the time line by another 6 months it allows for slippage and structural changes along with political horse trading that could water down the effectiveness of any remedy to this sovereign debt crisis.

Will we ever reach the land of fiscal union?

Thus, if the summit delivers the blueprint then we could see the markets stage a bit of a relief rally, but ultimately remain disappointed. Added to that the 6-month window to create fiscal union would require immediate action from the ECB to act as a bridge from where we are now to where we want to be in land of fiscal union. This means 1, more liquidity support from the ECB and potentially an LTRO 3 to help sovereigns like Spain sell their debt until the delivery of full fiscal union from the EU.2, potentially a rate cut as early as next week from the Bank to help boost growth in the region by weakening the euro. Thus, a successful outcome from the Summit for the EU political classes could be a weaker currency, which may help boost exports in the region.

The single currency: medium-term weakness

Hence, we are not too bullish on the medium-term outlook for the single currency. We could see it rally back to the 1.2750 mark, even up to 1.29, however we then think it will fall away towards the 1.2350 lows from earlier this month and then even to 1.20. But it may be hard to see the euro drop lower than this because 1, a lot of people are short euro already and 2, if the Eurozone crisis steps up another gear then the dollar will be under downward pressure from expectations that the Fed will do more QE, but only if the situation deteriorates substantially from here.

While the summit in Brussels is dominating sentiment, a few other things have been going on in the background. Spain sold more debt than planned today (EU 3.8bn, vs. EU 3bn) but it had to pay up: 3-month yields rose to 2.362% vs. 0.846% at an auction last month. This is unsustainable. Although there are buyers when Spain's debt becomes cheap enough, the higher yields could lead the Spanish authorities to decide it's cheaper to go down the bailout route.

Talking of lax fiscal oversight...

The Eurozone's finances aren't the only ones under scrutiny. The UK proved that it could do with a little more oversight when it reported its third largest monthly deficit on record in May. The deficit was GBP17.9bn vs. expectations of GBP14.8bn. This was fuelled by a drop in tax revenue and a slight increase in public sector spending. The deteriorating economic picture in the UK doesn't give the market much faith in the UK government's deficit reduction plans, which could threaten the UK's triple A credit rating in the medium-term.

Japan goes into political meltdown mode

Japan was also in the news today, after the Lower house voted to increase the sales tax. It now has to be voted on in the Upper House and is expected to pass. While this is constructive for Japan's debt position (its debt-to-GDP ratio is 200% of GDP), it sets the scene for a political battle after the ruling DPJ party saw 57 members vote against the bill in defiance of party leadership. So what's good for the long-term fiscal health of Japan is bad for its short-term political future.

Market moves:

EURUSD is trapped in a fairly tight range as we mention above after some positive consumer confidence data in Germany and France released earlier, while the dollar is fairly flat so far today as investors adopt a cautious approach in the lead up to the summit. The yen was an early gainer on the back of the political ructions caused by the sales tax vote, but USDJPY has found a temporary bottom at 79.20. 79.50 and then 79.80 are the near-term resistance levels to watch.

The pound has recovered nicely and is testing resistance at 1.5650, after stalling post the deficit figures. This pair is likely to be driven by sentiment in the lead up to the EU summit. Right now UK economic weakness and the prospect of more QE from the BOE next week is having less of a negative impact on the pound, than the EU crisis is having on the euro. Hence EURGBP is looking very vulnerable and fell below 0.8000 earlier. However, on a short-term basis 0.7980 should act as good support as this pair is looking much oversold on the hourly MACD.

Brent is recovering and stocks are fairly flat today as markets take a breather after yesterday's sell off. However, we think this is mere temporary respite as we lead up to the summit.

Best Regards,

Kathleen Brooks| Research Director UK EMEA |

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