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At the time of writing Spain has gone to the polls and everyone is expecting the conservative Popular Party led by Mariano Rajoy to win. The result should be known some time during the Asia session. In recent weeks new governments in the most stressed Eurozone nations have caused a short-lived relief rally, and the same could happen this time except the rally could be stymied very quickly indeed.

Firstly, the Communist Party is expected to take a respectable third place in the elections behind PP and the Socialists. They have polled well in the run-up to the elections, but oppose more austerity and would rather see more public spending to boost growth and a cut in working hours to relieve unemployment. If this party does poll well expect it to cause some indigestion over breakfast on trading floors across Europe. Public spending is a toxic word around Brussels right now and the concern will be that Communists  in control (albeit a tiny fraction of the total number of seats in the Spanish Parliament) will only delay reforms and fiscal consolidation measures, which will cause more uncertainty and fear in Spain's sovereign credit market. While the jury is still out on the effectiveness of austerity during this de-leveraging process right now that is the line Europe has to toe and any deviation (or attempted deviation) from this may hurt sentiment, in my view.

More importantly, Rajoy asked for 30 minutes from the markets to sort out Spain's debt problems, and 30 minutes may be all he gets. Although Spanish bond yields fell back below 6.5% on Friday the spread between Spanish and German 10-year debt is nearing the crucial 4.5% mark. First the markets freak out about 10-year bond yields approaching 7%, now the key word is the 4.5% bond spread with Germany as this tends to be when the bond clearing houses like LCH Clearnet raise margin requirements for bond holders making sovereign debt more expensive for traders to hold, thus triggering a sharp sell-off of debt. Spain is close to that critical level at 4.4%. When Italy had its margins hiked it caused a mass panic in the bond markets - pushing Italian debt firmly above 7%, the end of the Berlusconi era and a mass sell-off in risk assets. LCH Clearnet has to be fair and apply the same treatment to Spain as it did to Italy, so expect shock waves across asset classes if Spain's bond market comes under more pressure next week.

While Europe has been firmly in focus for months now, the US always has the potential to drag the limelight back its way, and it could do so this week. The latest news from Capitol Hill is that Congress has failed miserably to find a way to cut $1.2 trillion off the Federal Budget over the next 10 years. A deal really needs to be hammered out by tomorrow in order for the bi-partisan Deficit Committee to agree to the cuts by Wednesday's deadline. Since these cuts wouldn't come into play until January 2013 (conveniently after 2012 Presidential elections) missing the deadline won't cause a government shut-down or a US default on its debt like the scare back in August. But in these fractious times Congress is hardly giving the right impression. One would have thought that America would watch what is going on in Europe and try to pretend things are going ok since its heavy debt load dwarves that of Italy's. But instead politicians are choosing to pick the scab off August's wound and add to market uncertainty and jitters.

Combine this with debt auctions next week for France, Spain and Italy along with Thanksgiving-thinned holiday markets and we may be at the start of a fairly volatile week.

Although Spanish and Italian bond yields fell back on Friday they are still in critical territory. The positive news was that the ECB was considering lending to the IMF to purchase Eurozone debt and try to stabilise the region that way. That sounds like a particularly dysfunctional way to do business in my mind, and after this weekend the pressure is growing on the ECB to step in and control this crisis. However, ECB President Draghi sounds even less willing to help than before; in fact weekend reports suggest that the ECB is considering cutting down its debt purchases. Since it and some domestic banks are about the only ones left in the markets who want to buy Eurozone debt, combined with some major debt auctions coming up this week, the crisis could notch up yet another gear.

Perhaps Spain's Rajoy should ask the ECB for 30 minutes. The Central Bank is the only institution that can step in to calm the market and buy some time before private buyers' restore confidence and feel safe entering European sovereign debt markets again. While I am sure this conversation has been hashed out many times in Frankfurt it is beyond me why this hasn't been implemented. The debt crisis in Europe is now a chronic condition that isn't managed very well and threatens to cause a credit crunch, surely Germany's high command realises that deflation is a bigger threat at this stage than hyper-inflation...

Right now the bond markets are still suggesting things are more serious than the FX markets and we tend to think the bond markets are less capricious and have a more stable, reasoned approach to how they function so we go with them. Eventually other markets will follow. EURUSD fell 2% last week and the next support to watch is 1.3410 - the base of the Ichimoku cloud chart. However, the resilience of the single currency shows there is something more going on here. I read an interesting article this weekend about why the euro is so buoyant: it's all because of the recycling of petro dollars, which can act as a hefty counter-balance to European banks' de-leveraging programme. Thus, if the euro falls off a cliff oil would have to do so first.  Good luck trading.

Best Regards,

Kathleen Brooks| Research Director UK EMEA |

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