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This weekend we waited to see if the US would avoid a government shut-down and pass a new spending bill including an extension of the payroll tax cut and unemployment benefits. This was meant to be wrapped up by this weekend before the politicians go off for their Christmas break, but - unsurprisingly - there's an 11th hour drama.

After the bill was passed by the Senate on Saturday, House Republicans now threaten to veto it. So this vote could miss the deadline bringing with it excess volatility on what is a normally a very quiet week in the markets.

The spending bill, particularly the extension of the payroll tax cut, is considered vital to ensure the momentum of the US economy. This has been the one stabilising force on the global economy and financial markets throughout the escalation of the debt crisis, however political risk heats up again next year. Even if the spending bill is approved by the House, the payroll tax extension is only going to last two months before the rigmarole starts again. A further downgrade of the US next year on the back of political stasis can't be ruled out.

Talking of downgrades, Fitch joined the S&P and put the French on credit-watch negative late on Friday. It also said that without the ECB stepping up to the plate then a resolution to the crisis seems beyond reach. Thus, even though the French may complain that the UK needs to be downgraded before France, the truth is that we have a central bank that prints money and by having the ability to do so makes us more credit worthy than France. The ECB seem unwilling to change their stance hence the threat of downgrade in the region remains alive. Fitch also put the peripheral nations on credit-watch negative and Moody's downgraded Belgium.

The problem for Europe is that growth is grinding to a halt. The latest evidence of this is from Ireland where the economy contracted 1.9% in the third quarter after expanding in the first half of this year. This was due to falling consumption and investment rates and put in questions Ireland's position as the poster child of debt reduction and harsh austerity measures. Ireland is set to impose more austerity next year; however this may now be in doubt, much to the consternation of Germany.

The Irish government knows it is in a difficult position next year. The entire currency bloc is due to hammer out the details of the new Treaty to include more fiscal unity and harsher budget rules in January before voting on it in March. Already the Irish Minister of State for Finance has suggested to the Irish press that if Ireland is to agree to a new Treaty then its debt burden will need to be slashed. Cutting debt burdens doesn't seem to be the best way to kick-start a new era of financial discipline in the Eurozone, which may hinder Ireland's chances of success at securing better terms on its bailout loan.

TV station Al Jazeera had a good interview with Klaus Regling, the CEO of the EFSF rescue fund, this weekend. He said that if just one country from the Eurozone was downgraded (read France) then it may not affect the fund's triple A credit rating, however if there was more than one country downgraded then the fund's credit rating would undoubtedly be threatened. He also said that the EFSF hasn't been offered as a product for outside investors to buy, so the leverage process has yet to begin.

A story on the front page of today's Sunday Times reported on the preparations being made by the UK government to evacuate British ex-pats in the case of a banking collapse in Spain or Portugal. This could include a similar response to the evacuation of UK citizens from Lebanon during the 2006 war with Israel. So a collapse of Santander or Banco Popular could see the arrival of British war ships on the Iberian Peninsula - how would EU membership hold up then?

As we start the week the euro has opened above 1.30 in the Asia session. But as we wait (and expect) a French downgrade any time now the single currency's ability to hang on above this handle looks shaky at best. So as we have continued to say, any periods of strength in EURUSD, EURGBP and EURJPY should be ripe to sell into.

Ahead next week the data calendar is fairly light.US housing market data, MPC minutes from the UK and a meeting of the Riksbank where it is expected to cut rates by 25 basis points, are the highlights. Spain also auctions short term debt.

So it looks like the US and Eurozone will start 2012 as it started 2011, with plenty of political risk that threatens growth and for the Eurozone its future survival. This will be the last Sunday update until the New Year, enjoy the holidays.

Kathleen Brooks| Research Director UK EMEA |

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