(Update quotes, adds comments)
By Michelle Chen
LONDON, July 2 (Reuters) - Sterling rose against a weaker euro on Monday as optimism following last week's euro zone summit agreement waned, exemplified by Finland objecting to using the euro zone's rescue fund to buy government bonds in the open market.
The pound's gains came despite weak PMI data, which showed UK manufacturing contracting for a second month. It added to market expectations the Bank of England will opt for more asset-buying quantitative easing at its policy meeting on Thursday.
Analysts said market-focus on developments in the euro zone meant sterling's movements were driven largely by euro.
The euro slipped after Finland said it would block the euro zone's permanent bailout fund from buying government bonds. The Netherlands also indicated opposition.
The euro fell 0.5 percent against the pound to 80.20 pence, taking it closer to chart resistance at the psychological 80 pence level.
"The move in euro/sterling is more related to the euro story," Lee Hardman, currency economist at Bank of Tokyo-Mitsubishi said. He forecast the euro would fall to 79 pence in three months time.
European leaders surprised markets last week by agreeing to let their rescue fund inject aid directly into stricken banks from next year and intervene on bond markets to support troubled countries. Doubts lingered, however, it would solve the crisis.
A firm break below 80 pence would leave the euro on course to test the 3-1/2 year low of 79.505 pence hit in mid-May.
Against the dollar, sterling rose initially to a one-and-a-half-week high of $1.5722 , with traders citing demand from Middle East accounts, though they said a reported options expiry at $1.5700 could influence trade. It later pared gains to trade down 0.1 percent at $1.5688.
Analysts said the pound was likely to move lower against the dollar if worries about euro zone debt problems increase as investors seek the safety of the U.S. currency.
"If euro/sterling moves slightly lower, and euro/dollar drops more sharply below $1.20, then cable (sterling/dollar) will drop below $1.50. We expect the pound and the euro to trade quite closely, and the dollar will outperform both," BTMU's Hardman said.
MORE QE AHEAD?
The Markit/CIPS purchasing managers' index for UK manufacturing activity rose to 48.6 in June from May's three-year low of 45.9. The data was better than forecast but left the index below the 50 mark dividing growth from contraction and still pointed to the BoE opting for more easing.
"Manufacturing activity is still contracting and the trend is still very weak ... Clearly it's not going to change any plans the Bank of England might have," said Neil Mellor, currency strategist at BNY Mellon.
The BoE is expected to top up the 325 billion pounds of cash it has already pumped into markets with another 50 billion when it meets on Thursday as falling inflation gives it more scope to support a fragile economy.
"I think it would be very surprising if the Bank didn't do additional asset purchases this week," said Michael Derks, chief currency strategist at FXPro.
Analysts expect a decision to expand QE would weigh on the pound although the impact could be limited because further monetary easing is already widely expected and because the market remains focused mainly on events in the euro zone.
"The talk of QE has been around for a week or so and sterling has not reacted that much. It's all about the euro zone crisis, more than anything else," BNY Mellon's Mellor said.
He said the pound would see "a knee-jerk reaction lower" but said in the longer term if economic growth could be accelerated by the measures it would be positive to the currency.
He expected the euro to fall towards 79 pence in the short term and said it could move towards the lower 70s if it broke 78 pence, but he saw the pound weakening against the dollar.
(Additional reporting by Jessica Mortimer. Editing by Jeremy Gaunt.)
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