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The markets are currently trying to digest and decide what price action should be based on a raft of news out over the weekend. Europe is dominating. Spain's bond yields are back above 6% this morning and the speed of the ascent is worrying. Added to this, over the weekend we heard from EU authorities that they now expect the IMF to cough-up more cash to support the Eurozone's bailout fund at its meeting this coming weekend. The prospect of more cash from the IMF is not a given. Some of the largest donors including the US seem unwilling to pledge more money, while Japan has said that it won't commit more money until it is given assurances the EU is doing all that it can to stem this crisis. Reports suggest Japan could contribute another $60 billion to the fund with the UK contributing another GBP 10 billion; however that may not be enough to boost the EFSF/ESM hybrid fund, which already holds EUR 800bn, to a size that is deemed big enough to ease concerns about Spain and Italy.

The near-term funding constraints of the currency bloc's most financially fragile members are of great near-term concern. Today France auctions short-term debt at 1400BST/ 0900 ET. But by far the most important debt auction of the week is on Thursday when Spain plans to auction 2 and 10-year debt. This is going to be a test of market sentiment for Spanish debt and right now the signs don't look good. 10-year bond yields rose nearly 15 basis points at the London open to over 6.1%, which is perilously close to the 7% level that is deemed bailout territory. If bond yields keep rising at their current pace then we could easily hit that level by Thursday, essentially pricing Spain out of the capital markets altogether. But will the EU authorities allow Spain to go to the wall? We don't think so. We fully expect the EU authorities to step in and either re-start the ECB's SMP programme or announce some pre-emptive agreement with the IMF to boost bailout funds in the coming days.

We don't expect any problems at today's French auction, but the Presidential elections - the first round of voting takes place on Sunday - are a cause for concern. Socialist candidate Hollande has seen his lead extend against incumbent Sarkozy in recent days. More worrying is the growth in support for hard-line left-wing candidates. This is worrying since this party could come in third. Thus, we could see Hollande extend his anti-austerity, anti-fiscal pact rhetoric in the coming days and weeks to try and win back some of the support that currently has a preference for minority left parties. A win for Hollande would complicate the crisis. Although it is likely that he would toe the European line eventually (especially if France was threatened with rising bond yields) at this more dangerous phase of the crisis any signs of discord between Europe's two de-facto leading nations - France and Germany - could dent market sentiment even more.

Spanish bond yields, weak European bank stocks and a rising dollar and yen are all signs that risk aversion has gripped the market. We expect the market pressure to continue and European peripheral bond yields to remain at elevated levels.

China also grabbed the headlines at the weekend when it widened the trading band for the renminbi from 0.5% to 1%. This means that the yuan can now move 1% in either direction on any given day. There are a couple of things to take from this: 1, China will continue with its capital market liberalisation programme while it goes through its leadership transfer this year and 2, the yuan can move in both directions, so just because the band is widened does not mean a stronger yuan - it could mean a weaker yuan especially if Eurozone strains remain driving safe haven flows into the dollar. Thus, the impact on risky assets like the Aussie is probably negligible in the short-term. A free-floating currency goes hand in hand with a domestic-focused economy, which in the long-term is Aussie negative as it may signal reduced demand for Australian shipments of iron ore and other minerals that are associated with China's thriving export sector. It could also be euro negative as Beijing seems fairly set on reducing its FX reserves which means less reserve diversification, which was a major pillar of support for the single currency throughout the sovereign crisis.

Market moves:


EURUSD has already tested the air below 1.30 this morning and a convincing breach of this key psychological level now looks all but inevitable. 1.2950-70 is a key support zone below 1.3005. The news from S&P, the rating agency, that it affirmed the UK's triple A credit rating and was not putting the UK on negative watch, unlike Fitch or Moody's, should sustain the pound as safe haven theme and act as a cushion if risk sentiment drains from financial markets this week. Although GBPUSD is likely to weaken in line with the euro, good support lies at 1.58 then 1.5770, while 1.5970 is still the level to beat on the upside. We prefer to trade the pound long against the euro. However it is approaching a key support level at 0.82 (a 4-year low), so this level could be extremely sticky. Thus, we could bounce higher from this level towards the 0.8250 level, but we think that any strength in this pair will be used by the market as an opportunity to go short. If we were to break below here it would suggest a new paradigm for the single currency.

There has been no notable impact from the Chinese news as the Eurozone woes are dominating the markets. AUDUSD is trading between 1.0310 and 1.0350 today, although it is vulnerable to a break below 1.03 if risk aversion continues to dominate the markets. 1.0220 should act as good support if weakness persists.

Overall, risky assets look vulnerable and are likely to take their lead from the euro and peripheral bond yields, in particular.

Best Regards,

Kathleen Brooks| Research Director UK EMEA |

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