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German Chancellor Merkel's no total joint liability in my lifetime comment from yesterday will go down as the quote of the crisis so far. It looked like Italy's Monti might have grabbed that title when he said last week that the currency bloc's leaders had one week to save the Eurozone, but Merkel's is better than that. The fact she is only 58 and has many years in front of her is the clearest message yet that this crisis is far from over.

Could the first signs of optimism be creeping back into the market?

The markets are still range-bound as we lead up to the summit. The cautious tone has been replaced by some optimism creeping back in to the markets that Europe's leaders may deliver a positive surprise. So what would be deemed as positive: while a full blueprint for fiscal and political union that had broad agreement from all currency bloc members is likely to be a step too far at this this time, markets may be placated by any sign that the leaders of the currency bloc, political differences aside, still have the will to save the euro.

In our EU summit preview we say that the most realistic outcome from this summit is some vague pledges for a road map to fiscal unity and more solid steps towards banking union. If a beefed up banking sector watchdog is formed then we could see the markets take this as a positive first step towards 1, fiscal union and 2, politicians working together to create a centralised European authority. So we can't rule out a positive market surprise after this summit, however any rallies in EURUSD to 1.26 and then potentially to 1.2750 could be met with sellers as the path to fiscal union is likely to be strewn with event risk and risk aversion. You can read our full EU Summit preview here:

The battle between the Austeritists and joint liability brigade begins

The battle between the Berlin austeritists and the French/ Spanish and Italian joint liability brigade is heating up. The wave of political rhetoric coming out of Germany has turned into a tsunami. Merkel and Schaeuble have been speaking today. The Chancellor shut the door yet again to Eurobonds, while Schaeuble pointed out that Germany practices what she preaches by managing to balance growth with consolidation efforts. He also said that Germany would have eliminated its budget deficit entirely by 2014.

It seems like Spanish PM Rajoy's pleas for this EU summit to ease Spain's access to funding in the financial markets may have fallen on deaf ears. Germany's harsh stance could make Madrid's funding plight even more severe. Rajoy also said that he would push to abolish the senior status of the ESM rescue fund. This means that European authorities could be put at the front of the queue if a bailed out nation needs to re-structure its debts in the future, pushing private investors further back the line. Rajoy has a point here, Europe should not squeeze out private creditors by subordinating them vis a vis the ESM. However, countries like Finland are demanding seniority and won't even lend to the EFSF without collateral guarantees.

With less than 24 hours to go until the start of the summit, political agreement seems as far off as ever. The Merkel/ Hollande press conference tonight at 1845BST/ 1345 ET may shed more light on this since Paris and Berlin seem to hold such opposite positions on the future for the Eurozone.

Market moves:

As we wait for the summit there is a lot of speculation about what may happen in the next couple of days. However, in reality no one knows what the outcome will be. Unless you have extremely short time frames then the markets have been stuck in ranges for the last couple of days, particularly EURUSD and GBPUSD. EURUSD is stuck between 1.2450 - 1.2525, while GBPUSD is testing the top of its recent range at 1.5660. Interestingly, gold, oil and the Aussie continue to recover after sharp sell offs in recent weeks. Commodities have tended to lead markets during this crisis, so is the recent recovery in oil and gold a sign that the markets have made a bottom? We think not. The $3 rise in Brent crude since Monday is more of a gentle climb than a surge higher, which suggests that the prevailing downtrend could still be in place for some time yet. This leaves commodity currencies vulnerable in our view.

The stronger than expected durable goods orders in the US hardly moved the markets, and even USDCAD, which usually falls after good US economic data, is higher today as the better tone to durable goods (sales ex-transportation rose 0.4% in May vs. a 0.6% decline in April) reinforces the prospect that the Fed will remain on hold for longer, which is broadly dollar positive.

GBP jumped higher versus the dollar today after the best CBI reported sales results in June since early 2011. This suggests that the extra bank holiday over the Queen's Jubilee weekend could have had a nice impact on consumer spending. However, EURGBP has recovered after dipping below 0.80 yesterday. The move back above 0.80 today is mostly down to positioning in our view as 0.7980 is an historical low for this pair, and could limit further downside.

Ahead today the Merkel/ Hollande press conference is likely to dominate sentiment. Spanish bond yields have moved higher again today and are flirting with the 7% level after Merkel yet again rejected the idea of Eurobonds. Stocks in the US have opened higher, but the Chancellor's comments have knocked US stocks off their highs. The Nasdaq sunk on the comments as this index is extremely sensitive to global risk appetite and growth expectations.

Best Regards,

Kathleen Brooks| Research Director UK EMEA |

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