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Risk assets had a strong start to the European session, however the rally petered out by mid-way through the European session and the 80 pip drop in EURUSD after the cross tested the air above 1.3900 may drag other risky assets lower as we head to lunchtime. The trigger for the decline in the euro was comments from a German government spokesman who said that dreams of a swift solution to the sovereign crisis won't materialise.

Markets had been expecting the crises to at least stabilise by this weekend's EU summit, so comments such as these are not helping sentiment. We are heading into another week when the sovereign debt crisis continues to dominate. The recent rally in risk, which has seen EURUSD jump eight big figures, copper see its largest two-week gain in six years and stocks have their steepest rally since 2009, has been stunning. However it has been driven by expectations that Europe would solve the crisis quickly and efficiently, something it hasn't been able to do for the last 18 months. Added to this, the international community has given the European authorities eight days to come up with a package of reforms to 1, boost the size of the EFSF, 2, deal with Greece and 3, recapitalise the banking sector. Eight days is far too optimistic in our view. At the G20 finance ministers' meeting Europe officials rebuffed a proposal for the international community to boost funds at the IMF to help solve the crisis, instead choosing to solve its own problems. This leaves a very wide the margin for error (and disappointment for the markets) in our view.

The G20 may want Europe to come up with a cash-rich big bazooka solution, but Europe is backing away from this idea. According to newspaper reports, European officials do not want to use the ECB to act as a guarantor of sovereign debt, something that the US wanted Europe to agree on. In the absence of the ECB either acting as the currency bloc's financial back stop (like the Fed in the US) or allowing the EFSF to become a bank with a limitless borrowing capacity at the ECB then this crisis may not be solved as quick as some would like. In fact, Germany has said today that the search for a solution may last into 2012.

Europe and the wider community work on different time scales, which is finally being recognised by the markets and EURUSD has fallen below 1.3800 extremely quickly as investors are rushing in to the dollar. Due to the close correlation between the euro and other risky assets this may weigh on stocks as we head to the US open.

Press reports in Germany suggest that a new idea to solve the Eurozone crisis is gaining traction in German political circles. This plan hinges on a new European convention that would revise the EU Treaties as soon as possible. Indeed, Angela Merkel said that the measures needed to stem the Euro crisis would require treaty changes. Although a convention may help to speed up the process, it is unlikely to do so in eight days and is more of a medium-term measure. Added to this there has been criticism of Treaty changes from the UK, Austria and Ireland and any Treaty change would still need to be ratified by all 17 member states, so if Merkel and co want to reform how the EU works and potentially begin steps towards fiscal unity they have a lot of people to convince both inside and outside of the Eurozone.

As mentioned above, there is a dearth of economic data out of Europe today so the markets are extremely reactionary. The markets seem to be dismissing news from the EU commission that it would allow governments to use structural funds to help banks with their liquidity needs. It is no wonder, however, since this seems like a complicated procedure and there were no other details, for example what structural funds actually mean.

Fresh strikes are taking place in Athens today as we lead up to a parliamentary debate on Thursday to pass new austerity measures to ensure the release of more bailout funds. This vote has gone under the radar, however it remains vital as if the vote doesn't pass then Greece is on course for a disorderly default...

The risk rally of the last couple of weeks may have been stunning in nature, but there was always the risk that it was merely short-covering rather a directional change. Hence it is no surprise that as risk events like the Athenian Parliamentary vote and the EU summit this weekend get closer investors start to lose their nerve. Watch out for US Empire manufacturing and speeches from German Finance Minister Schauble that may dominate market action later today.

Data Watch:
13.30 US Empire Manufacturing Index Last -8.8 Exp -4.0
14.15 US Industrial Production Last 0.2 Exp 0.2
14.15 US Capacity Utilisation Last 77.4 Exp 77.5
14.30 EU Schauble speaking
15.35 EU Stark speaking

Best Regards,

Kathleen Brooks| Research Director UK EMEA |

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