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The big news of this session is that risk is rallying on the back of a few factors: 1, better than expected Chinese trade data (although the detail of the report was a bit sketchy) and 2, news from rating agency Fitch that a French downgrade is not on the cards, that Germany's top rating is safe and that Austria is in no immediate danger of losing its triple A status. This is seriously good news for the Eurozone and removes one of the risks that were weighing on euro-based assets.

Less good news was that Fitch said that Italy was ripe for a downgrade and afterwards it said that those countries currently on review (read Italy) could face a 2-notch downgrade. This could cause a market wobble if it comes to pass. Italy is currently rated A+ by Fitch. This denotes a low expectation of credit risk, however a two notch downgrade could see them down into BBB+ territory, which Fitch says means there is currently a low expectation of credit risk, but adverse changes in circumstances and in economic conditions are likely to impair its capacity to meet its financial commitments. This is also the lowest investment-grade quality, and with EUR 337bn of debt to issue this year, a downgrade of this magnitude will not do Rome any favours and suggests that high interest rates for GBT's are here to stay.

As we lead up to the Italian bond auctions on Thursday and Friday bond yields are uncomfortably high with the 10-year still yielding 7.12% and the 2-year yielding just below 5%. Buy what does all of this mean for risk? In recent sessions the euro has taken the brunt of weak European data with other risky assets like global blue-chips and commodity currencies able to rally. This week's auctions will be a good test to see if this dichotomy in asset markets can continue. We have seen the euro trade more in line with European bond markets and the Eurostoxx banking index, which are currently stable at the weaker end of their recent ranges. That should come as no surprise as banks parked another record breaking amount of deposits with the ECB overnight - essentially meaning that all the LTRO cash sucked up before Christmas is now back with the ECB. Unicredit had another mare of a day and is now down more than 30% in just 4 sessions.

Greece is also back in the news as time runs out for it to pass its next test by the Troika in return for its 8th tranche of bailout funds. The focus is now on talks with private sector bond holders to negotiate haircuts. This needs to be negotiated, possibly above the 50% already planned, for Greece to get its money yet Hedge Funds who own Greek debt are rebelling at the prospect of slashing Greece's debt burden further. For investors they may want to allow Greece to go to the wall to get CDS insurance pay-outs, but this is a risky strategy since the EU/ IMF could force through 80% restructuring or higher without support from private bond holders that would not trigger a CDS payment. So expect the financial community to use delay tactics on this. If Greece doesn't get the money then it could default on March 20th. As we lead up to this pivotal date then we could see growing volatility in the markets.

So there are some very large stumbling blocks out there and the question now is can some signs of growth in the US economy do enough to distract the markets from Europe's on-going woes?

EURUSD was capped in a fairly tight range today between 1.2743 and 1.2818 on the back of some short covering, but 1.28 is proving too hard to fight. The 14-month low is still support for now at 1.2666; we will have to wait until later this week to see if we re-test those lows. While the euro did its best to rally today, it lagged behind the commodity currencies. AUD led the pack although 1.0350 in AUDUSD is the high for now. However, strong consumption data out of the US this Thursday and Friday could cause a rally that may fuel AUDUSD to test its 200-day sma resistance at 1.0415. Added to that weak China inflation data could also help the Aussie as it may make Beijing happier to loosen monetary conditions.

Commodity currencies along with stocks could do well on the back of expectations that the ECB will continue to provide liquidity that instead of being used to buy sovereign bonds could seep into other risky assets. That's why I like EURAUD lower if we get a dovish Draghi. Although we think that formal QE is still off the menu at the ECB, he is expected to say that its open door liquidity policy for the banks is alive and well. Even though EURAUD is at euro-era lows, we could see a dip back to 1.23 even 1.20 in the medium term, especially if the current theme of euro/ risk dislocation continues.

Ahead today the Merkel/ Lagarde meeting at 1900GMT is unlikely to deliver progress on the sovereign debt crisis. Watch out for earnings releases and also Germany's annual growth rate is expected to come in at 3% for 2011 when it is released at 0800 GMT, down from the 3.6% Q3 annual rate, which suggests demand slowed, but didn't fall off a cliff. More important is the forward-looking data, which is not so bright: industrial production was weaker in November falling 0.6% on the month. Also, watch out for Germany's budget deficit data.  If it comes in below 2010's 4.3% then markets could rally.

Tomorrow could be another meandering day as we wait for Thursday's debt auctions and ECB meeting.

Best Regards,

Kathleen Brooks| Research Director UK EMEA |

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