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If you take a cold, hard look at the facts of the European sovereign debt crisis: highly indebted member states, rising bond yields for the core economies and under-capitalised banks that hold the bulk of toxic Greek debt then you would be forgiven for thinking that investors would be trying to ditch their risky assets as fast as they can. But markets are not logical, they aren't driven by the big picture, rather they lurch from one headline to the next, even if there isn't a kernel of truth in them. For example, reports of a prospective EUR 2 trillion bailout fund to deal with the crisis once and for all was shot down by official sources but it still seems to be sustaining today's risk rally.

It's hard to think the markets are doing anything but setting themselves up for disappointment so we would urge caution especially as EURUSD tests 1.3850 mid-way through the European session. I am not clever enough to be able to predict what will happen at this weekend's EU summit. So far other people braver than I suggest there are a couple of outcomes: 1, the French route: a big bazooka fund of EUR1-2 trillion is used to backstop Europe's sovereign debt, re-capitalise the banks and bring stability back to the markets. 2, The German approach: the Eurozone becomes a monoline: insurer of the first 20%- 30% of losses of new sovereign issuances.

The second approach is more likely in our view as it would require fewer funds. The truth of the matter is that Europe can't afford for Spain or Italy, let alone France, getting into trouble. So the least expensive option is the insurance plan and this is most likely to fly this weekend in our view. But as we have said, if you were guaranteed 20-30% of your investment back on what is undoubtedly a risky asset why would you buy it when there are other assets out there with a higher chance of returning all of your money and maybe even some profits...

This concern isn't worrying the markets, however it is likely to keep a lid on risk and we could see some choppy ranges into the weekend. Added to this, a Greek austerity vote scheduled for tomorrow needs to be passed to ensure Greece can continue to receive bailout funds and avoid a disorderly default. Approx. 70,000 people have descended on the streets of Athens at the start of a 48 hour general strike that threatens to paralyse the nation. Reports say the police have fired tear gas and petrol bombs have been thrown, if this escalates then it has the potential to dent market sentiment later today.

Forex markets are leading stocks, and strength in EURUSD continues to mirror strength in equity markets. The pan European Eurostoxx index is up more than 1 per cent so far, and risk is brushing off the situation in Athens, focusing instead on the potential for a solution from Europe's big hitters to end the sovereign stalemate. The problem of course is that had the EU dealt with the crisis in Greece earlier then we wouldn't be in this situation today with French yields relative to German yields making a 16-year high.

But while FX and stocks are higher, credit markets aren't joining the party and Italian bond yields remain at a vulnerable 5.9%. Italy is next scheduled to auction debt on 26th October, however if rates remain this high we would expect to see the ECB enter the secondary market to try and lower the yields.

Elsewhere, the UK minutes were the main focus of the economic data releases today. They were quote dovish, with all nine MPC members voting for more QE. The Bank decided to act in October rather than wait for November and the Inflation Report. It also discussed adding purchases between GBP50-GBP100bn, eventually settling on a happy medium at GBP75BN. The bank noted that inflation is expected to fall sharply in 2012, that lending conditions remain tight and that the Eurozone remains the chief threat to UK confidence and growth levels. The pound hasn't reacted to the minutes, with FX being driven by market sentiment. GBPUSD is above 1.5800 and is moving in line with the euro and stocks, while EURGBP is broadly flat.

Yesterday risky assets were sold off for most of the European session before turning higher in the US session. Interestingly, the Aussie dollar was the first currency to start recovering towards the close of the London markets. This helped to drag the euro et al higher later in the day. This makes sense since the Aussie is the most risky currency in FX and due to this look at the Aussie to get a sense of the strength of risk sentiment. AUDUSD is still looking strong although it could run into some resistance at 1.0340 - the recent high.

Europe is in focus, although US CPI due in a few mins could also impact the market especially if core CPI reaches the 3-year high as expected.

Data Watch:
EU General Strike in Greece
BR Brazil Selic o/n rate announcement Last 12.0 Exp 11.5
13.30BST (0830 ET) US CPI Last 0.4 M/M 3.8 Y/Y Exp 0.4 M/M 3.9 Y/Y
13.30BST (0830 ET) US CORE CPI Last 0.2 M/M 2.0 Y/Y Exp 0.2 M/M 2.1 Y/Y
13.30BST (0830 ET) US Housing Starts Last 571K Exp 595K
13.30BST (0830 ET) US Building Permits Last 625K Exp 613K
13.30BST (0830 ET) US Rosengren (FOMC Non Voter) Speaking
13.45BST (0845 ET) NO Norges bank Press conference
14.00BST (0900 ET) US Lockhart (FOMC Non Voter) Speaking
19.00BST (1300 ET) US Beige Book released
21.30BST (1630 ET) US Lockhart (FOMC Non Voter) Speaking

Best Regards,

Kathleen Brooks| Research Director UK EMEA | FOREX.com

d: +44.(0).20.7429.7924 | f: +44.(0).20.7929.2010 | M: +44 (0) 7919.411.957 | e: kbrooks@forex.com| w: www.forex.com/uk

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