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By Kathleen Brooks | May 14, 2012 6:32 PM IST

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It has been an ugly start to the week for the bulls out there as risky assets have sold off sharply. European equities are down between 2-3% so far today. The euro has also been dragged lower and EURUSD is below 1.29, likewise, AUDUSD is also below parity. Not even healthy demand for Spanish and Italian debt at bond auctions this morning were enough to lift sentiment.

Spanish banks losing interest in sovereign debt?

Rome sold EUR 3.5bn of debt maturing in March 2015, with an average yield of 3.91%. Demand for the debt was stronger than at a similar auction last month. Madrid sold EUR 2.9bn of 12-month bills, just below its EUR 3 bn target and yields rose to 2.985% vs. 2.623% at an auction in April. Although demand for the debt was healthy, it was lower than at recent auctions. ECB data has shown a sharp increase in the amount of sovereign debt being bought by domestic Spanish lenders, who remain addicted to ECB funds. The ECB announced today that Spanish banks borrowed a record EUR 264bn in April, following EUR228bn they borrowed in March. However, if the banks start to reduce their sovereign debt purchases it is hard to see how Spain can avoid a failed debt auction at this stage, so bank borrowings from the ECB along with demand for sovereign debt auctions will be watched closely in the coming weeks.

Symbiotic links...

The banks are leading equity indices lower today. The Bloomberg 500 European banks and financial institutions' index is down approx. 2.5% at the time of writing. Due to the symbiotic link between banks and the sovereigns in Europe, whenever concerns about a Greek exit or a breakdown of the Eurozone hit the market then banking stocks trend to take another surge lower. Right now concern is focused on Greece, but the markets are already looking beyond Athens to the potential contagion effects a Greek exit could cause to Spain, Italy etc. Hence why Spain's Ibex 35 index is at its lowest level since early 2009. The volume of Ibex shares being traded has also spiked since the latest flare-up in the crisis suggesting that there may be further momentum to the downside for this index as the bears take control. The index is currently finding some support around the 6,800 level, but it continues to look vulnerable to another leg lower.

Austerity as a condition of Eurozone membership

EU authorities continue to point to the prospect of a Greek exit. The latest headlines suggest that the Greek left coalition (whose turn it is to try and form a government in the next three days) would be willing to take part in talks that include all political parties except the Far Right. This doesn't suggest that a government is likely to be formed anytime soon so a new election in a few weeks' time seems the most likely option. An official spokesman said that Athens could run out of cash in July, which makes further EU/ IMF bailout funds essential to keep Greece from defaulting in the near-term. However, according to the latest polls the anti-austerity party Syrizia would win a new election, which would make the release of more bailout funds extremely tricky. As we start a new week the Greek people need to decide if they want to stay in the euro or not, as the EU authorities are making austerity measures a pre-condition for future Eurozone membership.

Watch out for Greek political talks, which start again today at 1730BST, also the Eurozone finance ministers' meet today. The markets will be looking to see if there is any "Greek exit" strategy talk from the ministers after signs they are less willing to tolerate Greek political posturing. Overall sentiment remains fragile and there isn't too much economic data today to distract investors and traders. All eyes will be on the minutes of the FOMC meeting last month, which are released on Wednesday. Any signs of QE from the Fed could help to calm risk markets later this week as Fed liquidity may be a panacea to Greek political risks.

We have seen a pattern emerge in recent sessions where sentiment is weak in the morning before picking up in the afternoon, thus EURUSD may fid some support just ahead of 1.2860 as we progress towards lunchtime in London.

Best Regards,

Kathleen Brooks| Research Director UK EMEA | FOREX.com

d: +44.(0).20.7429.7924 | f: +44.(0).20.7929.2010 | M: +44 (0) 7919.411.957 | e: kbrooks@forex.com| w: www.forex.com/uk

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