The markets have changed their tune since Friday, stocks are rallying this morning and the dollar, after performing well in the Asian session, is now suffering as the euro attracts some interest. The single currency had fallen as low as 1.3360, just above the 1.3350 Fib level, it is now up at 1.3450- 80, which is still below Friday's close at 1.3550. However, we need to see it close above this level before it generates any longer-term interest.

This move is having an effect elsewhere and the euro is lifting stocks and oil. Even copper, which had a major rout on Friday, is managing to get in on the action. Precious metals are also higher after extremely turbulent price action on Friday. Gold has failed to act as a safe haven in recent weeks and has sold off along with other risky assets. This accelerated on Friday after the CME exchange announced that it had hiked margin requirements for gold, silver and copper. Margin requirements can rise in a falling market to help provide liquidity. This move by the exchange may have been designed to facilitate large-scale liquidations of the metals. However, today the recovery is mostly due to the dollar move.

The change in tone towards risky assets is mostly due to reports of a re-hauled EFSF rescue fund that would see its funds beefed up to more than EUR2 trillion, allow for Greece to have an orderly default on its debt and help to recapitalise the banks with national funds. Although this plan is lacking details and we still need to find out how it would be implemented and agreed by all the Eurozone nations it is a step in the right direction. This plan was hashed out at the IMF meeting in Washington last weekend, which suggests that this problem has gone global. It is not just something to be worked out by Europe's leaders, global political leaders also have a stake in the sovereign debt crisis coming to a neat resolution and they want their plans on a workable rescue fund to feature in the solution.

So Europe is now compelled to come up with a solution to the crisis by the next EU summit at the end of October. The wider community outlined the three main areas that need to be included: more funds for the EFSF to the tune of EUR2 trillion to ensure the fund could cover an Italian and/ or Spanish bailout. The next step would be a huge recapitalisation of the region's banking sector to reassure global investors that a default of Greece, Ireland or Portugal would not cause a global financial crisis. Those who couldn't find the funds in the private sector could get state injections of capital, which would be much higher than the capital short fall identified at the conclusion of the EU banking sector stress tests in June. The actual amount of recapitalisation necessary is likely to be hundreds of billions, much larger than the amount included in the last round of EU stress tests in June. Discussions are also under way to protect the ECB in the case of a member state's default. This would mean that the EFSF would provide the equity portion of the bailout funds (the most risky part) while the ECB would be a senior credit holder and would thus be more likely to get its money back. This should go some way to placate hawkish ECB members who disagree with the Bank's bond-buying programme.

So these are the conditions that the international community has given to the EU. The rally in risk this morning as news of the new plan was released shows that expectations have been built for a nuclear response from the currency bloc to contain the sovereign debt crisis once and for all. This is such a radical plan, and so much larger in scale than anything else the EU has tried to use that there is a chance this plan will not be agreed, especially by Germany. Its parliament votes later this week on the extension to the EFSF proposed during July's EU summit. This vote is both crucial to show the Parliament's commitment to Europe and obsolete since it is voting on measures that are now considered woefully inadequate.

So are investors being too optimistic that Europe's largest economy (and paymaster) will agree to the much larger internationally-designed plan to save the currency union? Of course it is not going to be an easy sell to the German taxpayer, but the cost of a disorderly default is higher, so it is likely that eventually a plan of this sort will be provided, but not without intense debate and some harsh conditions to protect against moral hazard or even some help from foreign central banks.

For now investors seem happy that momentum is building to find a realistic solution to the crisis complete with a target for the rescue fund. However, that means that EUR2 trillion is now the magic number: if the funds available are less than this it may cause bout of risk aversion.

Comments from ECB members were slightly at odds with each other today. Luxembourg's Mersche said that investors shouldn't just assume that there will be rate cuts; however, Austria's Nowotny said that cuts can't be ruled out and the ECB's forecast for growth and inflation may also be cut further supporting the case for rate cuts. These mixed messages have been largely brushed off by FX traders who are concentrating on the plans for a bigger and better rescue fund.

The German IFO index for September was released today. It beat expectations; however it continued its decline and the index that measures sentiment in the future fell to its lowest level since August 2009. However, after the result the IFO President said that he didn't see a recession for Germany and that the current business situation remains robust. He said there was a 50 per cent chance of recession in the US.

Elsewhere, the newest member of the Bank of England Ben Broadbent showed his dovish credentials today at a speech in London when he said he was reasonably close to voting for more QE earlier this month. He also reiterated that most officials see more policy stimulus as increasingly likely. He mentioned that the sovereign debt crisis and slowdown in the US, combined with stresses in the banking sector could weigh on the UK economy for some time, and so we may need a prolonged period of pound weakness to aid economic rebalancing. The pound fell on his comments, but it has since recovered in line with the euro. However, UK gilt yields are lower as bond investors continue to price in the prospect of more QE.

Stocks were looking technically oversold, so it is natural for them to have a pull back here. But without more details on the new EU rescue fund as well as a miracle to get something of this size into production, then we might not have a sustained recovery in the near-term. Ahead today some ECB speakers and US New Home sales are released. The Fed's Kocherlakota speaks later in Chicago; this should be watched closely as he voted against the latest round of the Fed's policy stimulus announced last week.

Data watch:
13.30BST (0830 ET) US Fed Governor Raskin (FOMC Voter) Speaking
14.30BST (0930 ET) US Bullard (FOMC Non Voter) Speaking on Policy making after the crisis
14.30BST (0930 ET) EU Bini Smaghi speaking
15.00BST (1000 ET) US New home Sales Last 298K Exp 285K
17.00BST (1200 ET) EU Wiedmann speaking
20.00BST (1500 ET) US Kocherlakota speaking on Sovereign debt
21.30BST (1630 ET) EU Liikanen speaking on Europe under stress ways ahead
23.50BST (1950 ET) JP Corporate services Price Index Last -0.5

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Best Regards,

Kathleen Brooks| Research Director UK EMEA | FOREX.com

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