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The rally in risky assets has been sustained throughout the morning of the European session. The chief driver is yesterday's Franco/ German summit where Europe's most powerful leaders Merkel and Sarkozy agreed to come up with THE PLAN to save the Eurozone by the end of the month. It's taken them two years to do last-minute bailouts and three rounds of bank stress tests, three weeks to help re-capitalise the banking sector and come up with a long-term solution to save Greece sounds a little bit optimistic. However, for now it suits the market's optimism that Europe's problems have turned a corner.

This is dominating markets at the moment, however we are cautious. Today's rally in stocks has been muted relative to last week's move higher, which could be down to a couple of factors: 1, we still don't have any details about the plan to save the currency bloc and we have to wait until the November G20 to find out more; 2, signs suggest that the re-capitalisation plan for banks will come with its own set of problems. Some countries can't afford to provide more funds for their banks without damaging their credit rating, this is particularly pressing for France.

But could doubts start to creep in about the efficacy of bank re-capitalisations? Bailed out lender Dexia held a press conference today and its CEO made it clear that capital was not Dexia's problem. Instead, it was the toxic sovereign debt on its balance sheet that was the problem. Putting more good money after bad is not the answer - instead massive write downs combined with access to liquidity is probably the only way to boost the long-term health of Europe's banking sector. But right now investors are just relieved that France and Germany are singing from the same hymn sheet.

The bulk of today's move in risk has actually been in the FX markets. Stocks are being weighed down by some negative news out of the banking sector and news that a Greek bank had to be nationalised. This caused the Eurostoxx bank sub-index to drop nearly 2% at the open, although it has since started to claw back some gains. It is also the start of earnings season for the third quarter. There have been a number of high profile profit warnings over the month, including Premier Foods on Friday. A lot of this has been priced into stocks already so traders need to watch out for corporate guidance on the future of earnings. We believe they will be cautious and earnings will depend on a pick-up in consumer confidence, so we are back to data watching.

As we mentioned in our earlier London Open report, stocks have recovered but right now they are trading in a sideways range. Until the outlook is clearer: either Europe's crisis gets solved and confidence picks up or Europe fails to deal with its problems causing confidence to crash off further, then we don't think there will be too much conviction in the direction of stock markets for the time being.

FX is far jollier this morning and the euro has had a stunning run. Today it is the least ugly of the three major currencies; and EURUSD is knocking on the door of 1.3600 after rising nearly 2% so far today. But how far can the euro rally without a solution to the crisis? Although Europe's leaders gave themselves a deadline by the end of October to come up with a plan, the markets will need to hear more in the interim to be able to sustain confidence that a solution is indeed waiting in the wings. On an hourly basis EURUSD looks overbought, it may attempt to get to 1.3650 - the highs last reached at the end of September - before starting to get sticky.

Overall, even if we are in a risk-on environment there are a lot of obstacles on the road, so we don't think asset prices will go up in a straight line.

The rating agencies are back on the wires today affirming France and Belgium's ratings after the latter had to bail out failed lender Dexia. However, the cost to insure the debt of France and Belgium against default is rising today - so could the CDS be leading the cart before the horse?

It's a public holiday in the US so the markets could be quiet this afternoon. There were some positive data surprises in France and Germany this morning with French manufacturing production rising in August and the German trade balance also improving. Looking further into the week Italian debt auctions, UK employment and in the US Fed minutes from its September meeting will be key. Politics are also in play. Slovakia is the last country left to vote on the changes to EFSF agreed in July. Slovakia's opposition party is against the bailouts and the has refused to support the ESM long term mechanism to support its peers in the currency bloc. It starts a parliamentary debate today and the vote is for tomorrow - if it does not pass then the EFSF cannot be expanded to EUR440bn, which is already deemed inadequate.

Overall, markets are still being driven by expectations that the European debt crisis will be cleaned up quickly and efficiently, any headlines to the contrary could cause a major shift in sentiment.

Data Watch:
18.00BST (1300 ET) UK Miles speaking on Monetary policy and Financial dislocation
00.01BST (1901ET) UK BRC Total Sales last 1.5
00.01BST (1901 ET) UK RICS House price Balance Last -23 Exp -24
00.50BST (1950 ET) JP Current Account Last Y990.2 Bio Exp 270.7
00.50BST (1950 ET) JP Trade Balance Last Y123.3 Bio Exp -704.3 Bio

Best Regards,

Kathleen Brooks| Research Director UK EMEA |

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