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European politicians have done a fantastic job of lowering expectations for the EU summit that begins today, which means that even the smallest breakthrough may cause a short-term relief rally once markets open on Sunday night/ Monday.

A German official dampened all hope that German would give up some ground at the negotiating table, when they said this morning that the problems in Spain and Italy were blown out of proportion and conditions must be attached to all EU aid. Added to this the meeting between Hollande and Merkel yesterday did not produce any headlines. This suggests to me they weren't able to agree on anything. Thus, as we enter this summit the two de-facto leaders of Europe - Germany and France - appear to hold diametrically opposite positions on the future for the euro.

Any agreement on a roadmap or future milestones towards fiscal union is going to be extremely difficult to achieve at this summit if the political rhetoric is to be believed. However, there were some signs yesterday that investors were concerned the EU leaders could call their bluff, which led to some short-covering. We have heard that some large macro hedge fund-types have been buying short-dated call options around the 1.2450 mark as insurance against their short euro positions in case the summit delivers a positive surprise.

However, that didn't stop a bout of market jitters causing the euro to break out to the downside of its near-term range earlier this morning when EURUSD fell through 1.2450. The trigger was a weaker German employment report for June (the unemployment rate rose to 6.8% from 6.7% in May) and also the comments from the German official, which sapped sentiment from the market. EURUSD and USDJPY are the weakest performers today. Even the Aussie, which had performed well in the Asia session, could not sustain itself above 1.0120 and fell back towards 1.0070. 1.0020 remains key support, which is a recent low.

The 10-year Spanish bond yield rose above 7% at one stage today, although it had fallen back to 6.98% at the time of writing. An Italian bond auction went ahead with little fanfare. Rome managed to sell 5-year and 10-year debt. It paid the most since December to sell EU 5.4BN of debt, just below the top of its EU 5.5bn target. The 10-year debt sold with a yield of 6.19%, while the 5-year yielded 5.84%. This is lower than yields at the end of last year, but is still unsustainably high. The 10-year - 2-year yield spread is also at fairly stressed levels as you can see below, which could only get worse if the summit doesn't deliver the goods later this week.

What needs to be achieved?

So what could help risk to recover and credit risk in Spain and Italy to moderate? As we mention above, the bar is extremely low. Although we have more faith that steps towards banking union will be achieved before fiscal union, the markets are looking for political harmony from this summit. The northern core seems at odds with the southern periphery (and France). This was reinforced when the Finnish PM told reporters that he didn't like Eurobonds and that he prefers creditor status as part of the ESM rescue fund. This could make things worse for Spain and Italy's credit rating as it pushes private sector holders of their debt further down the pecking order in the event of a sovereign default. For EURUSD to rally on the back of the summit towards 1.26 and maybe even 1.2750 we need to see politicians agreeing, which is no easy feat.

Overall, if the summit delivers a disappointment then we may see stocks fall further than EURUSD. As we have mentioned in previous notes, we could see EURUSD dip to 1.2250 post the summit and it may even breach 1.20 again, but we believe further downside is limited due to 1, the fact lots of people are short the euro already and 2, USD gains could be capped if the Eurozone crisis notches up a gear as it puts pressure on the Fed to do more QE.

The pound also came under pressure this morning partly due to overall risk aversion and also due to weak UK economic data. The final reading of Q1 GDP was unrevised on a quarterly basis at -0.3%, however the annualised rate was revised lower to -0.2%, and the current account and business investment were also weaker. This reinforces the prospect of more QE from the BOE at next week's MPC meeting, and has knocked sterling. GBPUSD is finding support above 1.55, however if Eurozone event risk heats up post the EU summit then we could see back to the 1.5350 lows from earlier this month.

Watch out for US initial jobless claims data later and its final reading of Q1 GDP. Headlines out of the EU summit are also likely to be major drivers of the market this afternoon.

Best Regards,

Kathleen Brooks| Research Director UK EMEA |

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