The Decline of Pound Sterling and its Impact on the UK Economy

The Decline of Pound Sterling and its Impact on the UK Economy

The Pound Sterling (GBP) continues to face considerable pressure as the S&P Global UK Manufacturing PMI data remains below consensus. This indicates that UK factory activities have remained subdued due to weak demand from both the domestic economy and export markets. The recent data release shows that the Manufacturing PMI remains below the 50.0 threshold for the 17th consecutive month. This contraction in economic activities is a cause for concern and is reflective of the deepening recession fears in the UK economy.

The release of the weaker-than-projected S&P Global Manufacturing PMI for December has resulted in a nominal sell-off of the Pound Sterling. The factory data, which was lower at 46.2 compared to expectations and the previous reading of 46.4, indicates a contraction in economic activities. This decline in manufacturing output is accompanied by a frosty demand backdrop, with new orders sinking further as conditions remain tough in both the domestic market and key export markets, notably the EU. The downturn has also led to a decline in manufacturers’ confidence, which has dipped to its lowest level in a year. This has prompted renewed cost caution, leading to cutbacks in stock levels, purchasing, and employment.

One of the major areas of concern for the Pound Sterling is the speculation surrounding the timing of possible rate cuts by the Bank of England (BoE). Given the current state of the UK economy and its exposure to a technical recession, market participants expect the BoE to start cutting interest rates from May. However, BoE policymakers have been cautious about endorsing interest rate cuts, but the likelihood of a recession may force the discussion about reducing interest rates. This uncertainty is further exacerbating the struggle for direction in the Pound Sterling.

The UK economy is at risk of a technical recession, as indicated by the latest estimates from the UK Office for National Statistics (ONS). The economy shrank by 0.1% in the third quarter of 2023, and the BoE does not expect any growth in the final quarter. If the UK economy contracts in the October-December period, it will signal a technical recession. This alarming prospect has compelled BoE policymakers to consider rate cuts earlier than previously projected, with market participants hoping for a reduction in interest rates from May instead of the previously projected August.

Investors are anxiously awaiting the release of the S&P Global Services PMI data for December later this week. This economic data is expected to remain steady at 52.7. The outcome of this data will provide further insights into the current state of the UK economy and its impact on the Pound Sterling.

On the US Dollar front, the US Dollar Index (DXY) has shown signs of recovery, with investors focusing on the ISM Manufacturing and Services PMI, as well as labor market data. The broader appeal of the US Dollar remains bearish as market participants expect the Federal Reserve (Fed) to be the first among the Group of Seven economies to start a rate-cut campaign. These expectations translate into a projected reduction of interest rates by 25 basis points to 5.00-5.25% from March, with another rate cut anticipated in May.

The GBP/USD pair continues to show stability above the 20-day Exponential Moving Average (EMA), indicating bullish near-term demand. However, momentum oscillators are struggling to sustain in the bearish trajectory. The volatility around 1.2730 suggests that investors are slowly returning to trading after the festive week, but meaningful reactions in the FX domain will require fresh triggers.

Inflation plays a crucial role in currency valuation. Headline inflation measures price changes on a month-on-month (MoM) and year-on-year (YoY) basis, while core inflation excludes volatile elements such as food and fuel. Core inflation is the figure targeted by central banks, with a manageable level usually around 2%. When core CPI rises above 2%, it usually results in higher interest rates, which can lead to a stronger currency. Conversely, when inflation falls, it typically signals lower interest rates, which can weaken a currency.

In times of high inflation, investors historically turned to Gold as a safe-haven asset due to its ability to preserve value. However, in most cases, central banks raise interest rates to combat high inflation, which negatively impacts Gold as it increases the opportunity cost of holding the precious metal. Conversely, lower inflation tends to be positive for Gold, as it brings interest rates down and makes the shiny metal a more attractive investment option.

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