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Poor outlook for the Euro’s Q4 development

Poor outlook for the Euro’s Q4 development

After the worst quarter since the collapse of Lehman Brothers, equity markets welcomed the fourth quarter by continuing to fall. The Nikkei fell by 1.8% despite a slightly stronger than expected Tankan survey. Even an improvement in the Chinese non-manufacturing PMI from 57.6 to 59.3 failed to help sentiment as investors continue to fret over Europe’s debt crisis.

The Greek government acknowledged that it would miss its debt targets. The 2012 deficit is now expected to be 6.8% of GDP against a goal of 6.5%. For this year, the deficit is likely to be 8.5% of GDP against the 7.6% target agreed with the Troika. Greek slippage makes it difficult for eurozone finance ministers to sign-off on the second tranche of aid in their meeting in Luxembourg this evening. However, there is an increasing view that with GDP growth now much weaker than expected, Greece needs to be given some latitude in reaching its fiscal targets as it has managed to tighten fiscal policy be an underlying 12.5% of GDP over a two-year total, which is unprecedented. Further expenditure cuts would only depress growth further leading to ore budget cutbacks.

Pressure on eurozone leaders to sort out sovereign contagion once and for all could see a commitment to leverage the EFSF in order to give it more power to intervene. With the EU Commission, ECB and IMF Troika still negotiating with the Greek government, any aid disbursement has been pushed back to 13th October.

The euro fell to $1.3337 against the dollar this morning. Although markets are speculating about a rate cut by the ECB this week, the fall in the exchange rate and ECB intervention in bond markets act to loosen monetary conditions. We expect an expansion in liquidity operations, but doubt that Trichet will use his last meeting to reverse April and July’s rate increases. The euro is also softer against sterling, with the cross settling around £0.8584 this morning.

With the flash estimates of French, German and eurozone PMI manufacturing surveys for September already released, we believe that there will little reaction in a market that is concentrating solely on debt burdens.

We see more scope for a surprise in the UK, where consensus looks for the headline PMI index to fall from 49.0 to 48.5, which would show the pace of contraction accelerating. But the Lloyds business barometer showed a sharp improvement overnight, which implies that we could see a small bounce. We are expecting the index to remain unchanged at 49.0

The US ISM Manufacturing index starts payrolls week, with the employment subcomponent watched carefully. An above 50 reading, would point to stronger Q3 GDP growth.

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