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·         Madrid pays for success

·         Germany shines yet again

·         UK's incredibly sticky inflation problem

·         Market moves:

Madrid must be breathing a sigh of relief- it has avoided a catastrophic failed auction for another day. It managed to sell 12 and 18-month debt with relative ease today. It sold EUR 3.18bn exceeding its target of EUR 3bn, and the bid-to-cover ratio was also much stronger relative to a previous auction last month. However, the stronger demand was driven by a sharp increase in bond yields: the average yield Spain had to pay to sell 12-month debt was 2.623% vs. 1.418% at the last sale, while the yield on 18-month debt was 3.11% vs. 1.711% last.

Madrid pays for success


Markets have run with the stronger than expected demand and decided this auction was successful. Thus, the euro is higher and 10-year bond yields are 14 basis points lower compared to the open, and are currently below 5.95%. EURUSD is also testing resistance at 1.3150 after staging an impressive recovery since Friday's sharp sell-off. The bigger test is Thursday's long-term debt auction by Madrid, although some of the pressure is off after a Spanish official yesterday said the amount due to be auctioned on Thursday would now be reduced.

We continue to think that demand for Spanish debt will depend on the growth outlook and that remains incredibly weak. Thus, the recent calm in Spain's bond market may not last - although Madrid managed to sell debt today, it had to pay up to do so and rising bond yields only makes Spain's fiscal situation even worse in the long-term. We believe that the bond market will be extremely jittery until 1, Spain starts to grow (which could be years away) or 2, the EU authorities step in to ease the situation through restarting its SMP programme or boosting the size of the already enhanced EUR800bn EFSF fund.

Germany shines yet again


There was some genuine good news for the Eurozone today. The German ZEW index surprised on the upside and the forward-looking economic sentiment index rose to 23.4 from 22.3 in March. This reinforces the two-speed economy in the currency bloc after Spain's prime minister yesterday said he thought the economy had slipped back into recession in the first quarter of GDP.

News that Japan was pledging another $60bn to the IMF to help solve the Eurozone crisis has also helped to calm market nerves this morning. But it seems unlikely that the IMF will secure more funds from its members that would be big enough to truly ring-fence the weaker peripheral countries. But the markets aren't concentrating on that right now, and even though there have been pockets of weakness in the FX and equity markets, overall the markets have been remarkably upbeat especially since Spanish bond yields started rising. It seems like the markets need a big shock - maybe a failed Spanish bond auction, a collapse of a Spanish bank, or a Socialist victory in the French Presidential election to cause FX and equity markets to get in line with bond markets, which are still exhibiting risk averse price action. Although Spanish bond yields have come off their highs they remain elevated while US yields are below 2% and German 10-year yields remain incredibly subdued at 1.75%. Something seems amiss, especially since EURUSD volatility remains at its lowest level for more than a year.

UK's incredibly sticky inflation problem


UK inflation has proven to be stickier than expected once again. The annual rate of inflation rose in March to 3.5% from 3.4% in February, while the core rate of inflation rose to 2.5% from 2.4% - the first gain in 6-months. Although it has a long history of failing to keep inflation in its 2% target zone, the rise in prices in March reduces the chances of more stimuli from the BOE at its meeting next month, especially since economic signals picked up in March. Hence the pound has strengthened this morning.

Market moves:


Although it may defy reason why the euro has managed to be so resilient versus the dollar and avoid collapse, don't fight market sentiment. 1.3150 is thwarting the bears for now. 1.3056 - the bottom of the daily Ichimoku cloud (which signals the start of a downtrend) - is good support, while the level to beat is 1.3218 - the top of the cloud. Above here would signal further gains, however in the current environment it seems more likely that we will be trading in a 1.3050- 1.3150/70 range for the immediate term.

GBPUSD has stormed higher this morning post the stronger inflation data. 1.5950 resistance is currently being tested. 1.60 remains formidable resistance while 1.5837 - a cluster of daily smas - remains key support. 0.8220 remains the low in EURGBP. We are cautious on this pair and would sell it only on a pullback towards 0.8300. 0.8200 is a mutli-year low and thus will be respected by the market.

Stocks in Europe are being led higher by financials which are up a whopping 2.9% so far today. It's hard to know what is driving the gains - growth is still weak in the periphery and bad loan rates are rising in countries like Spain. Thus, we believe the upbeat sentiment is temporary. In the short-term the falling Spanish bond yields are also boosting sentiment towards Spanish banks, which hold a lot of domestic debt on their balance sheets.

Overall, sentiment is recovering but still looks fragile in our view as the fundamental picture has not changed enough to promote a full-blown recovery in Eurozone peripheral debt or in euro-based assets in our view. Traders should beware of vicious pullbacks as event risks including the long-term Spanish debt auction on Thursday and the French election on Sunday edge closer.

Best Regards,

Kathleen Brooks| Research Director UK EMEA |

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