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It has been an unsettled morning to say the least. After a fairly calm Asia session it looked like the markets would consolidate into the Fed meeting, which concludes tomorrow. But within a few hours it became clear: Europe is still dominating sentiment. News that the release of the audit on Spanish banks (billed as the final, all-encompassing view of the bad debts on Spain's banks' balance sheets) would be delayed until September rocked risk markets. In the current environment this is being viewed as negative and a sign that Spain has something to hide (i.e., more bad debts than we currently think). Madrid chose the wrong day to bury bad news as Spain's bond yields were already above 7% first thing. This caused a 10 basis point jump, which wasn't helped by a bond auction. Although the Spanish managed to sell EU 2.4bn of debt, and demand was strong, borrowing costs soared. The average yield for 12-month debt was 5.074%; this compares with 2.985% at an auction in May, and highlights just how much Spain's credit worthiness has deteriorated in a matter of weeks.

The writing on the wall for Spain ...


These borrowing costs are unsustainable and at this level Spain is on track to require a full bailout unless 1, its debts are underwritten by its financially strong Eurozone peers or 2, the ECB steps in to buy up its debt and ease pressure on its bond market. It's unlikely that fiscal union and pooling of debt is likely to happen any time soon, and definitely not before the EU summit at the end of the month. But at the rate its yields are rising, Spain doesn't have enough time to wait for Europe's politicians to decide whether or not to underwrite the debts of the weakest states, it needs action now. Hence why rumours the ECB had re-started its SMP programme caused yields to fall for the Iberian nation and also gave EURUSD a boost. The ECB has not settled any debt purchases for 14 weeks it announced yesterday, and the rumour that it had bought Spanish debt has not been confirmed. In fact there are now counter-rumours circulating that another central bank bought Spanish debt, not the ECB. So the plot in Europe thickens and yet Spain still looks like it is up the creek without a paddle.

Spain has nearly bumped Greece from the headlines. It appears that Pasok might be willing to join New Democracy in a coalition government, with Syriza in opposition. A coalition could be announced in the next few days. This would stabilise the political position of Greece and most likely lead to the next tranche of bailout funds being paid to Athens, thus avoiding default in mid-July, but that's all that it would solve. A coalition between the Conservatives and Socialists would be fragile at best, Syriza (who is anti-bailout) seem to be biding their time to take control when or if this coalition collapses. Thus, Greece is solved in the very short-term, but could still be at risk from leaving the Eurozone for as long as Syriza is a major force in the Greek government.

More QE for the UK?


There was also important economic data to digest this morning. The UK released CPI that missed the 3% expectation. Inflation in the UK slipped to 2.8%, the lowest level since early 2010. This increases the chances that the BOE will do approx. GBP50bn of QE when it meets next month, after the BOE governor suggested the time could be ripe for more stimuli at last week's Mansion House dinner. If the Bank doesn't add more QE then it would be a real credibility issue for the Bank. However, if it does do more QE then it opens itself up for criticism that it is a puppet of the government, who is in favour of more stimuli. The pound dived on the CPI data although GBPUSD found good support at 1.5620 - the 100-hr sma. The pure BOE QE play is long EURGBP, especially as the ECB hasn't expanded its balance sheet throughout the latest flare up in the sovereign crisis. EURGBP is testing resistance at 0.8060 - the Kijun line on the cloud. Above here opens the way to 0.8080 - the base of the Ichimoku cloud and the end of a technical downtrend. However, we still look to sell this pair on strength as EUR is sensitive to headline risk from Spain, Greece and the G20.

Market moves


The euro brushed off a weak ZEW reading from Germany. Even news that its strongest member was likely to enter a summer slump didn't stop EURUSD from rallying above 1.26 on the rumours that the ECB had intervened in Spain's bond market. While the markets are quick to sell rallies in EURUSD (1.2620 is the next resistance level to watch), the extreme short positioning in the market seems to be limiting further downside. Until we get the G20 and EU summit out of the way the outlook for the Eurozone, and thus the euro, are fairly cloudy. If there is a robust policy response from Europe to pool and underwrite weak members' debts then we could see a sharp and sustained rally in risk assets, if not then we could investors step off the side-lines and sell the euro once more.

It's unlikely the G20 will set the world alight when it concludes its meetings today. Any major structural changes to the currency bloc need to be agreed by all EZ members, most of which aren't in Mexico today. Thus, it could be another (expensive) talking shop for the world's leaders. The Fed meeting is far more interesting. We think there is a chance the Fed keeps its powder dry and doesn't do anything at this meeting, although there is a slight chance it may extend Operation Twist since it expires this month. Overall, we think upward pressure on the dollar is likely to persist for as long as the Eurozone crisis remains unresolved and the Fed doesn't extend its balance sheet.

We expect some choppy consolidation in the FX markets as we lead up to the Fed meeting. EURUSD could trade between 1.2550 and 1.2650, while USDJPY could trade between 78.60 and 79.30, its recent range.

Best Regards,

Kathleen Brooks| Research Director UK EMEA |

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