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The big news of the London session was the Merkel/ Monti conference in Berlin today. The usual pleasantries were exchanged between the leaders of the currency bloc's first and third largest economies, such as praise from Merkel for Italy's attempts at reform so far. In return Monti promised to focus on structural reform going forward. But the news with the biggest impact was Merkel's apparent softening towards topping up the ESM long-term rescue fund with more cash.

The yields of Spanish and Italian debt have not been able to fall in any meaningful way because of investor fears that there isn't enough money in the pot to rescue the two economies if they were to suffer a failed bond auction. This caused a brief respite for the single currency, which moved back above 1.27. However, this didn't last long, and EURUSD may now test the 1.2666 14-month lows reached on Sunday. Merkel said that if more up-front capital was committed then this would send a powerful signal to the markets.

The impact of these comments is worth watching. Spanish and Italian bond yields are lower/ prices higher, while stocks are lower along with the euro. Reports suggests there are large options expiries at 1.27 today, so we could hover around this level for the next few hours, which could keep other euro crosses range-bound. So why wasn't the euro given a bigger boost by the Merkel comments? There are a couple of reasons; firstly, if Germany softens on this point then it may eventually soften its opposition to QE by the ECB too. This is what more and more people are calling for to solve this crisis including Fitch, the credit rating agency.

Since more QE is euro negative then this may have cut short any rally in the single currency. The second point is that if Germany commits more money to Europe's bailout fund then you can be sure that Berlin will demand even more fiscal austerity measures from the periphery, which could weigh on growth even more -  with one hand Germany giveth, with the other it taketh away... Anything that could hurt growth in Europe is likely to hurt EURUSD since the US looks on a much more sound economic footing than the currency bloc.

The other day's other main event was news that German growth contracted in the last quarter of 2011 to the tune of 1% QoQ, which leaves it perilously close to falling back into recession. The good news is that domestic demand is picking up in Germany, so if the sovereign debt crisis is resolved then we could see confidence pick up quickly and a sharp rebound in German growth later this year. However, a German economic contraction doesn't bode well for overall growth in the currency bloc, which is also thwarting the euro's attempts to jump meaningfully above 1.27.

But it wasn't all bad news for Germany. Its estimated budget deficit shrunk dramatically last year to just 1% of GDP from 4.3% in 2010. So Germany is in a good fiscal position to weather a slowdown in growth compared to some other major economies. But it also strengthens Merkel's hand at demanding strict fiscal discipline from her Eurozone peers, which could hurt stocks as more austerity= less growth.

Perhaps Germany's strong debt dynamics were able to cloud the fact it is on the edge of recession, because at a bond auction today Berlin managed to sell 5-year notes with a pathetically low yield of 0.9% and demand was almost twice what was on offer. Strong demand for German and US debt has been a running theme of 2012, and suggests that 1, investors still want the safety of quality of government bonds, and 2, there is a consensus that the ECB will step in to keep yields low if economic conditions continue to deteriorate. So today's auction may be in expectation of an extremely dovish ECB tomorrow.

We expect Draghi to continue focusing ECB funds on banks rather than directly to sovereigns, which is a mistake since banks are hoarding the cash with the ECB rather than lending it out. This defies the point, and increases the chance of a credit crunch in the currency bloc this year.

Elsewhere, the EU has threatened Hungary with penalties including withdrawing future financial support since it hasn't cooperated with meeting its 3% deficit target. However, the truth is that many Eurozone members don't even adhere to this rule so the EU's threat may be a signal to Hungary to stop trying to erode the freedoms and independence of the central bank and imposing other restrictions, which strike at the heart of the EU's principles. Cue some back-tracking by the Hungarian government. PM Orban said that Hungary needs a strong, modern state to meet its economic goals -surely an independent central bank is part and parcel of a modern economic state?

So there is lots to occupy the market as we lead up to tomorrow and Friday's big events, added to this more rumours are going around the market that France will be downgraded in the next 12 hours.

Stocks are lower across Europe, while FX majors are mixed along with commodity currencies. Gold is managing to cling on above $1,635 per ounce, its 200-day sma. While we wait for the results of Spain and Italy's first bond auctions of the year and wait to hear just how dovish the ECB is, expect ranges to persist with no real direction in the markets.

One to watch: XAU/EUR


Gold priced in euro has been rising sharply as the euro has lost value against the dollar. XAU/ EUR is 8% higher since the start of this year, underperforming EURUSD, which is down 2.5% in the same time frame. Gold is a volatile commodity, so it tends to move in much larger increments than FX and it is fast approaching key resistance at EUR 1,300. This has been a key resistance level since October. We believe that in the current environment the euro is likely to continue its downtrend, which could see XAU/EUR clear this hurdle. Above here then EUR 1,320 ahead of EUR 1,380 come into view. Support lies at EUR 1,260 - a cluster of daily smas.

XAU/EUR daily chart




Best Regards,

Kathleen Brooks| Research Director UK EMEA |

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