Pound Sterling Sell-off Accelerates on Big PMI Miss, Down 0.60% against Euro

- GBP drops ahead of the weekend
- Alarming contraction in UK economy reported
- But bigger downward drag comes from decline in stock markets

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A sell-off in the British Pound ahead of the weekend accelerated on the release of data that showed the UK economy suffered a bigger-than-expected contraction in January.

A survey of UK businesses showed the impact of the third major nationwide lockdown was more severe than markets and economists had been expecting, with the all-important services sector suffering a particularly sizeable slump.

The Flash Services PMI survey from IHS Markit read at 38.8 vs. an expected reading of 45.0. The slump to 38.8 follows December's reading of 49.4, emphasising the severity of the measures introduced on January 03. A reading below 50 signifies contraction.

"The service economy was hard-hit by restrictions on trade and reduced consumer spending at the start of the year, with business activity falling at the fastest pace for eight months," says IHS Markit.

The Manufacturing PMI was however less impacted, with December delivering a reading of 52.9 vs. the previous month's 57.5 and the 54.0 that markets expected.

But the services sector accounts for over 80% of UK economic activity, and to get a clearer picture of how the broader economy is performing IHS Markit have a Composite PMI that weighs the two surveys accordingly.

This read at 40.6 vs. December's 50.4, which was notably lower than the consensus estimate for. 45.5.

Following the data, Sterling went lower: the Pound-to-Euro exchange rate hit a new 8-month high at 1.1324 on Thursday but is back down by nearly 100 pips at 1.1250 on Friday, the Pound-to-Dollar meanwhile climbed to 1.3745 on Thursday before retreating to 1.3678.

Above: GBP/EUR comes off its recent highs.

Despite the slump, expectations for a rebound in business activity are high.

IHS Markit query future expectations for businesses when conducting the PMI survey, and here there is some positive news.

"Despite a swift return to falling business activity at the beginning of the year, latest data indicated that UK private sector companies remain upbeat about their prospects on a longer-term basis. The index measuring business expectations for the next 12 months picked up slightly since December and was the highest since May 2014," says IHS Markit.

Survey respondents overwhelmingly attributed their positive business expectations to a successful vaccine roll-out during 2021. The UK's vaccine rollout is progressing according to plan, with a target to get the country's most vulnerable vaccinated by February looking achievable.

Secure a retail exchange rate that is between 3-5% stronger than offered by leading banks, learn more.

However, UK Prime Minister Boris Johnson said on Thursday that it might not be until early summer that restrictions are lifted, hinting at a potential government policy to fully eradicate the virus before opening up.

If this is the case, the forward-looking expectations of businesses might face disappointment and the negative impact of the lockdowns could have a more enduring and lasting impact of the economy as many businesses will not survive.

A failure by government to support micro businesses that are not eligible for any government grants or support other than through loans is being brought up by business representative bodies as posing a particularly acute problem.

Market Sentiment Weighs on the Pound

The negative data from IHS Markit merely accentuated a trend of decline that had already been present in Sterling since late Thursday.

The British Pound turned lower ahead of the weekend amidst a broader decline in global investor sentiment which saw global stock markets sell-off into the weekend.

The developments confirm the Pound's newfound correlation with broader market sentiment and trends now that the to-and-fro of Brexit negotiations are a thing of the past. The UK's 'beta' to markets appears to have risen over the past two weeks, rising alongside rising stock markets, but going lower when they fall.

In tandem with this relationship the Pound is lower in sympathy with a decline in European stock markets, that include a 1.0% decline for Germany's Dax and a 0.75% decline for the UK's FTSE 100.

According to analysts we follow, the decline in stock markets is however not driven by any major developments, leading to assumptions that a technical correction is underway and that the broader trend higher is still in place.

"Risk sentiment has waned marginally in Asia with the greenback moderately bid vs both G10 and EM. There has been nothing to drive this risk-off tilt overnight in Asia, and we suspect markets are consolidating amid a lack of new concrete catalysts beyond US fiscal. We continue to watch new policies under the Biden administration," says Kurran Tailor, an analyst with Citibank.

"GBP has mirrored AUD and NZD price action, trading 0.2% lower to 1.3705 at the time of writing," adds Tailor.

The correlation between Sterling and the Australian and New Zealand Dollars is another confirmation of the Pound's emergent 'risk on' status: both the AUD and NZD have traditionally displayed a strong 'beta' status to markets, rising and falling in tandem.

The Pound-to-Euro exchange rate hit a new 8-month high at 1.1324 on Thursday but is back down by nearly 100 pips at 1.1250 on Friday, the Pound-to-Dollar meanwhile climbed to 1.3745 on Thursday before retreating to 1.3678.

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Should the broader stock market trend of appreciation, which is now well established, ultimately resume and extend over coming days and weeks then the Pound could restart its rally.

However, there are some reasons to be concerned: the covid-19 crisis continues to grip the globe with new variants emerging, which could potentially upend expectations for a vaccine-lead recovery taking place from mid-year onwards.

"European equity markets drifted lower on Friday, following a global trend after mounting virus-related fears hit sentiment at the end of the week. The recent market euphoria fed by further stimulus plans and corporate results, peaked on Thursday as Joe Biden’s inauguration as President pushed US markets to record highs. Following that it seems most investors now feel the party is over and are back to the reality of the pandemic, after the situation worsened in many countries," says Pierre Veyret, a Technical analyst at ActivTrades.

Tighter restrictions could be put in place in the U.S. now that Joe Biden has assumed the Presidency, which could slow economic activity and prompt a consolidation or decline in stock markets which could in turn impact on Sterling.

But there are some domestic issues to consider when looking at the Pound.

In a monthly currency briefing strategists at Credit Suisse say there is a chance of Sterling appreciation in coming months should the UK execute a successful vaccination programme.

"GBP looks increasingly like a notable “Covid goes away” play in G10 space," says Shahab Jalinoos, Trading Strategist with Credit Suisse.

The market currently expects the Bank of England to cut interest rates by June 2021, but Jalinoos says if this pricing is pushed back, Sterling can rise. But, this will require the market to believe the vaccination process is proceeding at a pace to allow for the country to reach herd immunity.

"With the market still pricing in high odds of negative rates, if the UK actually manages to reach herd immunity relatively quickly due to a successful vaccination program, GDP and rate expectations could bounce, leaving room for general GBP outperformance," says Jalinoos.

Credit Suisse forecasts show the GBP/USD exchange rate could attain 1.40 this year, while the GBP/EUR exchange rate could achieve 1.15.