Revising down euro area forecasts...

Three headwinds to the euro area economy have loomed larger in recent weeks: (1) tighter fiscal policies, (2) bank deleveraging and tighter credit conditions, and (3) persistent and heightened uncertainty over the euro area sovereign debt crisis. As a result, we are revising down our forecasts: we now expect a contraction of 0.6% in euro area GDP in 2012, a marked cut from our previous forecast of +0.8%. Correspondingly, we now expect the ECB to cut its main rate to 0.5% by February next year.


Central scenario: elevated concern for the sovereigns

Our central scenario is for further muddling through in Greece, albeit with heightened uncertainty, in the context of a flimsy euro area safety net. The EFSF agreement of 27th October (increasing the firepower of the EFSF to €1trn) looks difficult to implement, as bond investors will require extended insurance and external investors may be deterred by the unstable euro area crisis resolution mechanism.


Central scenario or more turbulent outcome? A close call

The events of the past few days have underlined just how fragile the political situation is in Greece and how quickly contagion could spread. There are many downside risks to our central scenario, all of which would have severe consequences: we cannot rule out a disorderly Greek default, and we attach a non-zero probability to the possibility of a run on the banks due to uncertainty in some peripheral countries. The Italian situation is also increasingly unsettling, with the country about to present its third supplementary budget in fewer than five months, with little impact on sovereign yields.

source: Bank of America ML