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That is the question. Price action has been driven by expectations of future central bank policy over the last 24 hours. The improvement in the peripheral bond markets was down to comments from an ECB official who said that the Bank has the systems necessary to support Europe if things take a turn for the worse. This seems to have sustained the bulls in the bond market and Spanish 10-year yields are down 20 basis points in the last 24 hours, likewise the euro has managed to stay above the crucial 1.3056 level - the bottom of the Ichimoku cloud.

Has the ECB done enough?

However, can these comments continue to boost risk sentiment? We don't think so. While we fully expect the ECB to act if the crisis in Spain or Italy gets even worse we think that it will take comments from the head of the ECB Mario Draghi and a firm commitment of more action - either bond purchases through the SMP programme or even LTRO 3 - to cause a sustained risk rally. The markets may be focusing on the retraction in the 10-year bond yield but there are still some warning signs out there. The spread between 10-year and 2-year Spanish bond yields has started to narrow in the last few days. Although it is nowhere near as tight as it was back in November 2011, if the 2-year yield continues to rise at a faster pace than the 10-year yield then markets will get nervous. In recent weeks the prospect of Spain needing a bailout has increased. Greece got a bailout and then re-negotiated its debts and private investors had to take haircuts. If Spain gets a bailout then a much larger number of private investors could be at risk of haircuts. Thus, it is no wonder that while strains remain short-term Spanish debt could be at more risk from a sell-off than long-term debt. This is a development worth watching.

The problem with government

Spain's fiscal problems are mainly located in the autonomous regions. There were some interesting comments this morning from Spanish Deputy Minister Beteta who said that the central government made a mistake by creating mini states in the regions that have control of important departments like education and health spending. They added that there is nothing they can do now, but it brings up an important point: it is much harder to enforce fiscal consolidation when power over big budgets is de-centralised. This is what has made Greece's efforts at reigning in its deficit much tougher, if the same happens to Spain then its fiscal targets are at risk of getting missed, which could erode confidence even further sparking another dangerous leg higher in the sovereign debt crisis.

The Fed's doves move to the fence

The markets are on high alert from shifts in sentiment from global central banks. The speech from Janet Yellen last night, second in command at the US Federal Reserve, suggested that she may have softened her dovish stance. She said that the labour market had shown welcome signs of improvement and that she expected the economic recovery to continue. However, she tempered her positivity by saying that she considers a highly accommodative stance of monetary policy appropriate in the current conditions, but she added that she would be willing to adjust her views in response to in-coming information. Thus, Yellen has shifted from the dovish side to the fence. She is in wait-and-see mode, and although QE3 isn't ruled out, she left her powder dry when it comes to future policy decisions. This helped to boost the dollar especially against the yen as Treasury yields rose on the back of her comments (combined with a fairly upbeat Beige Book for April). USDJPY did look vulnerable earlier this week and 80.00 was in sight. The recovery has seen the cross move back towards 81.00 and until we hear more from the Fed then we believe this pair will remain range bound between 80.50 and 82.00.

Market moves

The Vix, Wall Street's fear gauge, still remains elevated relative to a month ago, although it has come off its most recent highs. So although on a longer-term basis volatility is extremely low, the market responds to changes in volatility and that has picked up in the past few days suggesting that investors could be suspicious of the recent calm in the markets. Bond auctions and central bankers will determine how far volatility spikes up; however, we do believe that in the end central banks will be there to sooth the markets.

But ECB action isn't the ultimate cure to this crisis; it is only a temporary respite as the ECB has found out since its LTRO auctions. The central banks can only sooth things when the situation gets really bad - so stabilisation in the markets doesn't mean that things are better, it just means that we are not falling off a cliff. The Eurozone sovereign debt crisis remains a big risk for the markets and could still disrupt things.

EURUSD remains range bound between 1.3150 and 1.3050. EURJPY has recovered slightly after finding support at 105.80 - the 200-day sma. This pair is very sensitive to changes in risk sentiment so we would expect it to recover along with Spanish bond yields. Likewise, the ultimate risk barometer AUDJPY has also continued to recover. It bounced off support yesterday at 82.50, which opens the way for a move to 85.00. We are either in risk on or off mode at the moment, and right now risk is on, which means the euro is protected (although the medium-term outlook is incredibly cloudy), the pound is doing well and Treasury yields are rising again, dragging USDJPY with it.

The results of Italy's long-term debt auction will be pivotal today along with US labour market data released this afternoon.

Best Regards,

Kathleen Brooks| Research Director UK EMEA |

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