The big news so far today has been the big data miss out of the UK - manufacturing PMI missed estimates for February to rise to 51.0 from 50.8, and instead plunged back into contraction territory last month at 47.9. So much for the UK's manufacturing recovery; sentiment is now as weak as it is in the Eurozone. More worrying for the government is that the positive impact of a weak pound doesn't seem to be boosting the export sector, and instead could be more of an economic hindrance as it pushes up import prices.
The pound slipped sharply on the back of this news and dropped as low as 1.5025 at one stage, although the psychological 1.50 zone is holding as support for now. The immediate driver for GBP may be the outcome of the sequester in the US. If the spending cuts are not averted we could see risk aversion start to build in the markets as the US growth outlook gets dented. However, it is not beyond the realm of possibility to see an 11th hour deal agreed between Republicans and Democrats after the markets close for the week. If this happens then the dollar could sell off boosting GBP, EUR and the commodity currencies.
The sequester could drive GBP in the short term
Overall, we think the pound will be driven by a few things next week: 1, the outcome of the sequester and 2, the BOE meeting and economic data all due next week. The pound is extremely sensitive to domestic fundamentals right now, if we see a miss in the service sector PMI when it is released on Wednesday, this could be the trigger for a sharper move lower in GBP to sub 1.50. Likewise, the BOE meeting next week could also determine the medium-term direction in sterling. Right now the market does not expect any change to rates or the Bank's QE programme, however, if the data continues to deteriorate then maybe a few more members might join King and co who called for more QE at the Feb meeting. I would argue that the risks to more QE at this meeting are neutral right now, but could depend on the outcome of the Feb service sector PMI released next week.
Funding for Lending not quite working...
Credit data didn't help the pound this morning as consumer lending only rose GBP0.6 billion, less than the GBP1.1 billion expected. The Funding for Lending programme has had a fairly weak impact so far. This also supports more QE as the BOE pulls out all the stops to get banks to lend. But perhaps the focus should be on the other way round: get people to start businesses and to borrow. Making it easier to start a business, but also providing training how to start a business, how to look for a gap in the market and how to manage your own start-up could be a better use of government money...
Evidence builds for more action from the ECB
I digress, the other big under-performer this morning was EUR. It fell after a double whammy of a record high in unemployment for January and weaker than expected inflation. The price data is the more important of the two from an FX perspective because the ECB recently sounded concerned about the drop in prices. Inflation fell 0.2% in February and is now below the ECB's 2% YoY inflation target. Thus, the ECB now has a powerful case to 1, cut rates further or 2, embark on some monetary easing to try and get credit to the real economy and get people spending again. We will get more detail on this from the horse's mouth next Thursday when ECB President Draghi holds his monthly press conference after the March policy meeting. But what could euro do until then? EURUSD is barely holding onto the 1.30 level this morning, and is already below a key support zone at 1.3085 - the base of the daily cloud. This suggests that we are now in a downtrend in EURUSD. 1.3010 is the 200-day sma, if we get a weekly close below here we could see further declines back towards 1.2850. Mario Draghi managed to weaken the euro substantially at last month's meeting, the question is can he do the same now that we look poised to fall below 1.30?
What next for the dollar?
Of course the euro's future will also depend on the direction of the dollar. If the sequester goes ahead today then we could see dollar strength as investors rush to the safety of the greenback. If it is avoided then we could see the euro and other dollar crosses recover. Markets can be volatile places when they depend on the capricious decisions of politicians...
Surprise GDP reading boosts SEK
Elsewhere, the SEK is one of the top performers after GDP was flat in Q4 beating forecasts for a 0.8% decline. This caused EURSEK to nosedive to a 5-month low below 8.4, this is a bearish development for this cross and could open the way for a sharper decline to 8.33 - a resting point from August when EURSEK was on its way up, which could now act as support.
There are some key economic releases this afternoon including US PCE and the manufacturing ISM. The latter will be important as it has been fairly volatile in recent months. The market expects the ISM to decline to 52.5 in Feb from 53.1 in Jan; however this index has beaten expectations in 4 of the last 5 releases, so the outcome is highly uncertain.
While the key driver of all markets will come from Capitol Hill today, it is worth watching out for Canadian Q4 GDP at 1330 GMT. This is expected to remain at 0.6%; however the market expects a decline in December of 0.2%. USDCAD broke above 1.0300earlier, the highest level since June 2012. The question now is, can it get back to the 1.04 highs from late May? This could hinge on the GDP data. Anything weaker than what is expected from Canada could give this cross the push it has needed. Whether or not it breaks fresh 12 month highs could depend on the sequester.
One to Watch:
Kathleen Brooks| Research Director UK EMEA | FOREX.com
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