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There have been some tentative signs that we may be stepping back into a risk-on environemtn. In June stocks outperformed Treasuries, financial stocks did well (ex. Barclays) and broadly outperformed utilities and more defensive stocks, gold prices closed up last week and volatility levels dropped. The chief driver was Europe. Politicians delivered the goods and took bolder action than the market hoped. Compared to a month ago Greece looks more secure within the Eurozone, Spain's bond holders won't be placed in a subordinated position in the event of a Spanish default and the ESM/ EFSF rescue facilities may become more flexible. Although the problematic debt is still there and there are unanswered questions such as the time line for the changes to the rescue fund to be implemented and whether or not the funds have enough money in them to be effective, these are fundamental steps in the right direction and, for now, the market seems to be placated.

So Europe may take a back-seat for a while as the market digests what the EU summit means for the markets. Also, the pro-active measures taken by the politicians may give the green light to more accommodative action from the ECB. The market expects a 25 bp cut from the ECB when it meets on Thursday. We don't expect any LTRO 3 or more liquidity for the banks, especially since the more flexible European rescue funds may be allowed to directly re-capitalise the banking sector down the line. So what could the rate cut do? We don't believe it will have too much of an economic impact as it is likely that austerity is dampening demand for credit, but a rate cut is symbolic as it could ease some pressure on banks funding costs and the costs of credit to the private sector, especially in the faster growing economies such as Germany. It would also highlight a willingness for Germany to accept higher levels of inflation that adds to the signals from the EU summit that Berlin is willing to give ground to save the struggling states of the Eurozone. That is what the market really wants: a protector of the currency bloc in the form of Germany. Thus an ECB rate cut could deliver more than meets the eye.

If the Eurozone crisis does take a back seat then we could see growth come back into focus. Euro-area unemployment rose to its highest ever euro-era level in May to 11.1%. This was expected and hardly had an impact on the market. Instead investors are looking to see if May/ June was potentially the bottom for the Eurozone economy and things will improve from here. The manufacturing PMI data for June was revised slightly higher to 45.1 from 44.8, which is still incredibly weak, but Ireland saw its PMI data rise at the fastest pace for 15 months to 53.1, the fourth consecutive expansion in the manufacturing industry. Ireland's manufacturing sector must be exporting to somewhere, so this could be a very small green shoot of recovery for the currency bloc.

UK PMI data also picked up to 48.6 from 45.9 in May, which is below the crucial 50 level but is moving in the right direction. The focus is on the BOE this week, which is expected to boost QE by GBP50bn when it meets on Thursday. This could help EURGBP to recover, however GBPUSD could prove resilient to more QE especially if the calmer tone to the markets persist.

Market moves:

There was some profit taking at the start of the European session, but since reaching g a low of 1.2610 we have seen a recovery. 1.2690 is a key resistance level in the short-term. Above there opens the way to a test of 1.2750 - the post Greek election high, that the markets failed to reach after the EU summit. Going forward we think two opposing forces could weigh on the euro: on the one hand a reduction in credit risk as Spanish and Italian bonds yields keep dropping, which is euro positive, and on the other hand the potential rate cut from the ECB that could erode the euro's yield differential and weigh on EURUSD. This pair could thus be range bound between 1.2550 - 1.2750 in the lead up to the meeting, as investors digest the outcome of the EU summit and decide if it is enough to keep the sovereign debt crisis on the back-burner for now.

EURGBP is running into some resistance at 0.8070 - as it continues to recover. We believe this pair could recover further potentially to 0.82 in the medium term, if bond yields continue to fall. The FTSE 100 is higher today, as financials recover. Even Barclays has recovered after failing to share the rally on Friday due to the Libor scandal. It is up nearly 10% today as the markets react well to the resignation of the chairman.

The ISM manufacturing index in the US is the key release later today. The market expects a reading of 52, which is moderation from May but is crucially above the 50 mark. If the market concentrates on the positives from the EU summit and there is no negative surprise from the ISM then we may see risk assets extend this rally.

Best Regards,

Kathleen Brooks| Research Director UK EMEA |

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