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Discussions between Greece and its private sector bond holders kicked off again today (a week after a deal was expected to be agreed), which has dominated news flow this morning. Reports suggest that the private sector is willing to accept a lower coupon rate, below their initial demands of 4%, in order to come to an agreement.

While we think a deal will be agreed in the next few days the real market moving news would be if the ECB gets involved. There is growing pressure on the Central Bank to take losses on its holdings (rumoured to be EUR 30-40bn) alongside private sector bond holders. However, there are others who disagree with this including Spain's economy and competition minister De Guindos who said that the ECB shouldn't take a haircut on Greece earlier this morning.

We believe that if the ECB was to bow to pressure and take a loss on its holdings the impact on overall market sentiment could be very strong. If the ECB is willing to share the pain of debt restructuring in Greece instead of piling it all on the private sector then it may help sentiment in Europe's bond markets, especially towards Portugal, whose bond yields have surged to multi decade highs.

There has been no single catalyst for this lack of confidence in Portugal in recent days, especially since Irish bonds haven't followed suit. However, its debt re-financing load is heavily front-loaded this year with more than EUR 24bn to shift, so this could be dampening sentiment, especially as under the terms of its bailout it will need to tap the markets in the next 6 months. Added to this Portugal was downgraded to junk status by S&P two weeks ago, which didn't help investor confidence.

Portugal also has a large current account deficit. But what is more interesting is that some analysts think that Lisbon's ambitious fiscal consolidation plan for this year, which is expected to drive the deficit down to 4.5% could hinder growth and thus its ability to pay back its debts. So once again we see this austerity/ growth/ fiscal consolidation feedback loop affect sentiment in the peripheral European bond markets: could the medicine actually be a poison when it comes to solving this crisis?

As you can see the challenges are massive, and if Portugal can't grow its way out of this crisis then there will be raised expectations that its debts will also need to be softly restructured. If the ECB steps in to share some of the burden of Greece's restructuring then sentiment could improve towards Portugal et al and we could even see some investors more willing to take the risk of buying Lisbon's debt at a fairly hefty discount if they may not have to shoulder all the burden of a Portuguese restructuring.

But, until we hear more about ECB participation then we are stuck in a range bound environment. EURUSD had a strong recovery this morning bouncing back from 1.3080 (now a key support level and 21-hour sma) to 1.3160. 1.3185, yesterday's high, is the next level to target. Above here opens the way to 1.3220. Sentiment was boosted by an extremely strong short-term Italian debt auction that saw Rome issue 6-month debt with a yield of 1.969% - the lowest since May. This has helped 10-year GBT's fall below 6%.

However, as ever with the Eurozone good news follows the bad. First thing this morning we heard that Spain's unemployment rate surged to a dramatic 15-year high of 22.85% in the fourth quarter and retail sales for December shrunk 6.2% on an annual basis, worse than consensus. Spanish bond yields have followed Italian yields lower. Spain is going through a painful period of adjustment, and will continue to do so for the foreseeable future, but the LTRO auctions by the ECB (next one due 29th Dec) has taken the pressure off the sovereign to re-finance the countries' troubled banks, hence why we have seen yields moderate to their lowest level since October even as the economy struggles.

EURGBP has also turned higher this morning. The next resistance level of note is 0.8410. This could act as serious resistance, however, and the pound has shown resilience even as we believe the BOE gets ready for more QE next month. Thus, we believe this pair will range trade and in the short term is a buy on dips to below 0.8350.

USDJPY has been another big mover overnight. Post the Fed meeting 10-year yields have plunged and that has been followed by a dip in USDJPY. It is currently testing support at 77.00, and the trajectory appears to be lower. We don't expect an outright collapse (otherwise we may get Japanese official intervention) so we could meander to the 76.65 lows from last week.

Stocks opened lower this morning but have since started to turn around after the good Italian bond auction and the prospect of the ECB participation in the PSI discussions. The outcome of today's Q4 GDP report from the US will be interesting. A good reading of 3% + could help boost sentiment, but may throw doubt on how serious the Fed is about keeping rates low into late 2014 as Bernanke said earlier this week. So it could be a volatile afternoon as investors try to decipher messages from Europe and the US.

Best Regards,

Kathleen Brooks| Research Director UK EMEA |

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