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The European stock markets are in recovery mode today as we wait for the Spanish bond auction at 0930BST to set the tone. This auctions will be closely watched as Madrid tries to sell long-term debt, however its significance should not be overplayed as the size of 2014 and 2022 debt that is scheduled to be auctioned is less than EUR3 billion, which should be easily sucked up by the market.

10-year yields have retreated from their highs of 6.1%, but they remain 80 basis points above their level a month ago. The key things for investors to watch out for are the yield and the bid-to -cover ratio. If Spain has to pay more to sell debt maturing in 2022 than what 10-year yields are currently pricing it could spook the markets causing risky assets to sell off. Likewise, if it can sell debt at lower yields this could spark a recovery rally.

But we wouldn't read too much into today's auction. A good result, for instance, can't disguise the fact that the economic situation is deteriorating sharply in the Eurozone's fourth largest economy. The bad loan ratio for Spain's banks rose to its highest ever level in February, while the Bank of Spain along with the IMF both doubted Spain's ability to meet its deficit targets for this year.

That is deeply concerning for a couple of reasons: 1, it means that we could get further upward pressure on Spain's bond yields if the economy gets even worse, 2, more money either from the IMF or the Eurozone to boost the rescue fund may not be  forthcoming if stringent fiscal targets are not going to be met.

The first quarter of 2012 was about optimism and recovery after the LTRO auctions, however the second quarter is more sombre as investors weigh up what is worse: weak growth or missed fiscal targets. Spain and Italy have both admitted that their fiscal targets for this year won't be met, and we doubt they will be the only countries to defy Angela Merkel and co and miss on fiscal targets in an effort to preserve growth. The risk with this strategy is that if fiscal targets are loosened then expectations for growth will be much higher, yet Europe's economies appear to be stuck in a weak growth rut so either way the risk of investor disappointment is high.

France also sells debt at 1000BST. Yesterday the markets seemed to wake up to the fact that the French election is only 3 days away and French 10-tyear bond yields rose above 3%. Its spread with German debt widened, while the cost to insure some of France's largest companies against default rose to multi-month highs. The Socialist candidate Hollande is ahead in the polls, which is considered a market-negative result. The markets haven't concentrated on France much as Spain has stolen the limelight and does not seem to be priced for a Hollande victory. Thus, there could be more volatility in the French markets in the coming days.

The other risk on the near-term horizon is the IMF/ G20 meetings this weekend. We heard from IMF chief Lagarde that the Fund has managed to raise a further $300bn for its financial stability fund, however this is not enough to ease market concerns about Spain, so that could add to the list of disappointments that could plague the markets in the near-term.

Market Moves:


The dollar is weak today, although the yen has sold off sharply after further hints from the Bank of Japan that it will pump more stimuli into the economy when it meets next week. The euro is recovering ahead of the Spanish debt auction as the markets price in the chance of success for Madrid today. However, as we said above we still think that a break of 1.30 is possible, especially as we lead up to the French elections.

1.3150 is capping the EURUSD bulls for now. 1.3100 is key support while 1.32 remains the resistance level for the bulls to beat. The key mover today is the pound. GBPUSD is testing key resistance at 1.6060. Above here opens the way to 1.65, and we have flagged this level as a game-changer for cable in prior notes.  EURGBP closed below 0.8200 yesterday, which is a key bearish sign as 0.82 was a support level dating back to 2010. 0.8180 is fairly sticky after the market looked oversold, but a break towards 0.8090 then 0.80 is now in view.

EURCHF is still incredibly close to the SNB's 1.20 floor. The SNB announced that Thomas Jordan would be the new President of the Bank and at a press conference yesterday. At the same press conference Jordan reiterated the Bank's commitment to the cap in Swissie gains. The risk for Jordan and co. at the SNB is that the French election combined with a disappointing fund raising effort at the IMF/G20 meeting this weekend will cause a wave of selling pressure causing the SNB to defend its peg and potentially take even more aggressive action like raising the EURCHF floor. It's an uphill battle for the SNB, though, and they will have to react to the way the Eurozone situation develops.

Bank stocks in Europe are fairly flat today after yesterday's sell off, we expect them to remain jittery today as we get the results of the bond auction and wait to hear the results from the French elections and the IMF/ G20 auction.

Best Regards,

Kathleen Brooks| Research Director UK EMEA |

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