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Referendums in Ireland, NFP's in the US and the last week of pre-election polls in Greece suggests that it could be a fairly volatile few days. A couple of developments have helped boost sentiment since the Asia open this morning, including 1, signs that the pro bailout- lite New Democracy Party in Greece is ahead of the radical left Syrizia party in pre-election polls and 2, the news that Spain is planning to re-capitalise its banks with its own sovereign debt. This has spread hope that 1, Greece may be able to stay in the Eurozone after all, and 2, that a Spanish bank may not collapse in the near-term. This was enough to cause the dollar to fall after last week's highs and risk assets to recover.

Recovery so far: fragile and shallow...


However, the recovery so far remains shallow and fragile. By using its own debt to re-capitalise banks Madrid could be accused of 1, monetizing its own debt and 2, increasing the link between the sovereign and the banking sector and ultimately eroding the collateral quality that ECB holds on its balance sheet. Even if New Democracy gets into power in Greece, its margin is fairly meagre at the moment and the party leader has hinted that he may want to renegotiate the bailout, which could cause the markets to freak out at some stage.

Although EURUSD bounced off of 1.25 after briefly dipping below that level late last week this looks more like a short squeeze to us. For a prolonged rally in risky assets like the euro we need to see either a fundamental shift in events in the Eurozone, a sharp pick-up in Chinese growth or a 200k+ Non-Farm Payrolls number  on Friday. The chance of a strong NFP number is the most likely to happen, but even then the market only expects 150k, and the number surprised on the downside last month.

No easy Grexit


Rating agency Fitch reminded the markets of how devastating a euro-exit would be in a statement released earlier. It said that if a member state left the euro it could cause a wave of corporate defaults as the currency it returns to immediately loses its value. This is a potent reason for Greece to remain in the Eurozone and could see the Greek people tone down their anti-austerity rhetoric in the weeks' leading up to the election on June 17th.

Spanish PM Rajoy has been speaking today. He is denying reports that his government has asked the ECB about its plans regarding its injection of sovereign debt into Bankia (which needs approx. EU 19bn). However, while it may be able to do this for Bankia, what about its regional governments? Catalonia asked the central government for money last week and Rajoy has said that the regions have liquidity problems. Can Spain by-pass the ECB and print its way out of the crisis by using sovereign debt to pay for assets of dubious quality with no guarantee things won't get worse and the central government will get its money back? This concern may be one reason why Spanish bond yields have reached their highest level since November, just below 6.45%. It seems only a matter of time until they attempt the 6.7% high reached on 25th November 2011.

Market moves:


We pointed out yesterday that it might be time for the euro to play catch up. The euro hasn't started playing yet, but the spike higher in Spanish yields is definitely one to watch. Commodities have led the rally in the FX and equity markets today and Brent crude oil is up nearly $1 per barrel. EURUSD didn't like it above 1.26 and has been in a fairly tight range since this morning between 1.2560 and 1.2620. A close above 1.2620 this evening would suggest that a deeper pullback could be on the way.

So why are investors' not filling their boots with risky assets that have been sold off for months? That is what happens in normal situations especially when certain things are as oversold as they currently are, like the euro. However, we are not in normal times and until we know for sure that a Grexit is off the cards and Spain is safe then a breach of 1.25 in EURUSD could trigger a move towards 1.20 in the medium-term.

Best Regards,

Kathleen Brooks| Research Director UK EMEA |

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