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The last 24 hours have heaped even more pressure on Madrid. First there was Standard & Poor's two notch rating downgrade for Spain from A to BBB+ with a negative outlook. Second, was a further deterioration in the unemployment rate in the first quarter. S&P's rationale for the downgrade was down to 1, the possibility that the government will need to provide further fiscal support to the banking sector and 2, the deterioration in the budget deficit trajectory for 2011-2015. S&P also mentioned the significant risks to Spain's economic growth, which could weigh on the country's creditworthiness.

Spain now has the same rating as Ireland after S&P affirmed Ireland's rating at BBB+ with a negative outlook. It sounded fairly impressed with the Irish government's proactive and substantive reaction to the financial crisis. It said that Ireland's outlook remained negative due to 1, the challenge of reaching its 3% deficit target by 2015 and 2, if Ireland votes against ratifying the European Union's Fiscal Treaty in its referendum on May 31 then it could lose its eligibility for funding from the ESM.

There are a couple of things we can deduce from this: 1, the rating agencies are merciful to counties where governments make concerted efforts to reign in unsustainable finances and 2, the Eurozone's Fiscal Pact and its threat to economic growth is reducing the credit-worthiness of some countries in the currency bloc. All paths seem to lead back to the Fiscal Pact, which adds to the urgency to implement a growth pact such as ECB President Draghi proposed earlier this week.

Spain's economic outlook is particularly challenging. The unemployment rate for the first quarter rose to 24.44%, up from 22.85% in Q4 2011. The tragic social consequences are all too clear: one in four people are unemployed, and if the economy doesn't start growing again then Spain could be thrust into an outright depression. This makes the government's budget targets even harder to achieve in our view, as welfare costs rise, which could make further credit downgrades more likely. We have mentioned before that Spain's generous unemployment benefits could make the unemployment rate look worse than it actually is, as people may be dis-incentivised to look for jobs when they first become unemployed. However, there is no denying that the picture is grim, especially for the young where the unemployment rate rises to 50%.

Spanish bond yields surged to 6% today where they fell back. This is a key resistance level; however it's hard to see yields fall substantially without official support. Yet again, we see much more stress in the Ibex (Spanish stock market) than we do in the bond market. It is being led lower by financials, and is about 120 points away from its post-Lehman Brothers' low in March 2009.

Elsewhere, the BOJ expanded its Asset Purchase Programme last night as expected. It increased its asset purchases by 10 trillion yen, at the upper end of expectations. However, BOJ Governor Shirakawa said that the Bank has no intention of adding monetary stimulus each month; although it will keep easing until the 1% inflation target is within sight. But will the BOJ manage to keep government pressure at bay? The government may change the law to have more influence on the Bank and it wants the inflation target raised to 2%. Thus we can't rule out more prolonged stimuli being pumped into the economy and potentially weakening the yen in the long-term.

Market moves:


The euro dived on the back of the Spain news, however 1.3150 held as good support. For another leg lower to materialise we may have to wait for the Q1 2012 US GDP data, which is released today at 1330BST. The markets expect a 2.5% expansion in the economy and for personal consumption, a major driver of economic growth, to expand by 2.3% up from 2.1% in Q4 2011. This release could cause some volatility as a solid report would reinforce the diverging growth paths between the US and Europe and may cause downward pressure on EURUSD. We believe 1.3250 is the high for this pair, although there is good support at 1.3150 then 1.31 (the 100-day sma) and then 1.3050 (the bottom of the daily Ichimoku cloud). It could also boost the CAD due to the strong trade links between Canada and the US. USDCAD has been under pressure but has found some support ahead of 0.9800. A good reading of US GDP could see a breach of this level as the CAD tends to react well to upside US data surprises. Alternatively, a weak reading could hurt Canada's currency.

The yen has been the surprise mover. After initially rallying on the BOJ move, USDJPY then gave back all of its gains above 81.50 and fell back to the 80.50 level as the yen attracted safe haven flows post the Spanish downgrade. This is unlikely to please the government who has been trying to talk down the currency in recent months.

Interestingly, the dollar has started to weaken as we lead up to the mid-European morning and stocks in Europe have clawed back some earlier losses. As we said, we could be range bound until we get more direction from the US GDP data later.

Best Regards,

Kathleen Brooks| Research Director UK EMEA |

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