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The pound sunk to a 4 week low against the euro yesterday

The pound sunk to a 4 week low against the euro yesterday as the stream of poor UK economic data shows no sign of abating.

Yesterday, the leading think tank the National Institute of Economic and Social Research (NIESR) reported that the UK economy shrank in the three months to July. They estimate that output declined by 0.2% during the period in contrast to official data published by the Office for National Statistics (ONS) which showed UK GDP falling by 0.7% in the three months to the end of June.

The NIESR did however advise that its latest data is likely to be distorted by the additional bank holiday and the moving of the late May bank holiday for the Diamond Jubilee celebrations. It warned that it could take another two years for the UK economy to get back to previous levels.

“These estimates suggest the UK’s large negative output gap is widening. We do not expect output to pass its peak in early 2008 until 2014” according to the report.

This morning, the Bank of England (BoE) publishes its latest quarterly inflation report. The majority of analysts expect the BoE to slash UK growth forecasts to close to zero from the 0.8% predicted as recently as May. The BoE is also expected to downgrade inflation forecasts amid a weak economy in a double-dip recession that has been hit by the euro zone sovereign debt crisis and slowing domestic demand. In May, Governor Sir Mervyn King said the UK would not be “unscathed” by the euro zone “storm”. The BoE is expected to say in its latest Inflation Report that the UK economy will come to a standstill this year with virtually zero growth in 2012. The likely reaction is an increase in speculation as to further monetary loosening, either in the shape of further money printing (quantitative Easing) or a cut in UK interest rates or both.

Against the dollar, the most traded currency pair, the euro was broadly unchanged yesterday as optimism increased after Germany backed the ECB’s plan to buy Spanish and Italian bonds and Greece agreed with the Troika to strengthen policy efforts.

However, a warning from analysts at Goldman Sachs that Europe’s single market for financial services is fragmenting amid mounting fears of a euro break-up. The Goldman report shows the degree to which banks across Europe have reined in cross border lending, leading to a deep decline in flows of credit from Northern Europe to the South. The trend is being driven in part by national supervisors, which are pushing local banks to build up capital and liquidity at the expense of other EU countries.

Elsewhere, the Norwegian Krone rose to a six-week high against the buck after Norway’s industrial output data beat forecasts. Factory output rose 0.8% in June, compared with an expected 0.4% increase and the Australian dollar rose to a five month high against the pound after the Australian central bank maintained interest rates unchanged at 3.5%. The markets had widely predicted a 0.25% interest rate cut.

Meanwhile, the Canadian dollar benefited from oil futures surging to a 12-week high on Tuesday as short-term supply worries pushed up prices.