Foreign Exchange: Pound Falls As Economy Contracts

As the Office of National Statistics reported yesterday that the UK gross domestic product slumped to -0.5% the Pound fell heavily.

Winter conditions really hit consumer spending in 4th quarter causing the UK economy to suffer a surprise contraction. This news hurt all the more as economists had forecast a 0.5% gain in the final three months of 2010. Even taking out the impact of bad weather, the ONS confirmed that growth in the fourth quarter would have been “flattish”.

The degree of the contraction signals that the UK economy is floundering and hurtling towards a second recession. Gross domestic product is unlikely to improve in the first quarter of 2011, as the budget cuts take hold, and rising unemployment and an increase in VAT hit consumer and business confidence.

With the Pound having already declined sharply on the foreign exchange markets, investors are suggesting that it Pound could trade as low as 1.1370 versus the Euro and 1.47 against the U.S Dollar. To that end, Euro and Dollar buyers may wish secure an exchange rate before the Pound suffers further losses over the coming weeks.

The governor of the Bank of England Mervyn King has this morning said the current bout of rising inflationary pressures is temporary and that price growth will slow to around 2% next year. King was trying to preserve a sense of credibility for letting consumer prices remain above the government’s upper limit of 3% for ten straight months and even indicated that inflation could peak above 5%.

Rising inflation combined with slowing or negative growth will spark fresh concerns over stagflation, which means that the BoE face a very difficult balancing act over the coming months. With the ONS report yesterday it seems very unlikely that there will be an interest rate increase in the summer – previously forecast following the sharp rise in consumer prices earlier this month.

EUR/USD

The Euro traded close to a two-month high against the US Dollar, before a report this week that is expected to show that confidence in the European economic outlook improved for an eighth straight month. The single currency found support close to the $1.3580 area against the Dollar and rallied firmly through the course of the day.

Whilst US consumer confidence data was stronger than expected, the Dollar was unable to stop the slide. The latest Case-Shiller house price index recorded an annual decline of 1.6%, which reminded markets of the fragile housing sector. The FOMC interest rate announcement this evening is expected to result in a no change to policy and that may also hamper support for the Dollar.

In the Euro-zone, there was strong demand for the European Financial Stability Fund bonds, which helped maintain a more optimistic tone towards the Euro. The single currency rallied to $1.37 area last night and was holding just below the level this morning.

Market Analysis by Adam Solomon, Torfx

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