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August 3rd 2011: Preview - PMI services slump would trigger Bank of England action

 

Always a vital monthly release, the UK services-sector PMI index has been given extra importance by the manufacturing sector contraction reported on Monday.  If the services index also drops to below the 50.0 level, then Sterling will come under very heavy selling pressure with GBP/USD likely to slide rapidly to the 1.60 area. This looks unlikely, but any outcome weaker than 52.0 would certainly undermine UK confidence and potentially trigger losses in the 50-60 pip range with steeper falls cushioned by the run of weak US and Euro-zone data.

There is scope for Sterling to drift weaker into the release with markets anticipating a relatively weak release. Any short Sterling positions should be run with a tight trailing stop loss with an eye to re-enter shorts  above 1.6320 if the currency is pushed higher by a stronger than expected release.

The services PMI index is a key indicator of economic health and Sterling’s underlying performance will remain strongly correlated with this data, especially as services are dominant within the economy.  The Bank of England will also pay very close attention to the data ahead of Thursday’s interest rate decision. Two MPC members over the past week have warned over the possibility of another UK recession late in 2011 and there has been further background discussion that further quantitative easing might be required if the economy deteriorates further.  A weak release would push the Bank of England much closer to further easing during the Autumn and a figure below 50 would make action almost inevitable. The media debate surrounding another UK recession would intensify and Sterling would attract very unwelcome headlines.

Looking at the last 12 releases, 6 have been weaker than expected while 4 have been stronger and 2 close to expectations. The large number of UK holidays in April and early May did distort economic trends and this report should be clean of holiday impacts which will give a truer picture of underlying demand within the economy.

There is little doubt that the economy remains trapped in a weak growth environment as consumer spending remains under pressure and confidence has been undermined further by the weak PMI manufacturing survey.  A solid reading for the services sector would provide near-term relief and allow Sterling to retain its defensive status for slightly longer.  A sharp decline would allow a mood of pessimism to become even more deeply entrenched. Political pressures would also intensify as economic fears increased with a much greater risk of government divisions.  

In relative terms, Sterling will continue to gain some protection from fears over the US and Euro-zone outlook, especially with Euro-zone pressures intensifying again. The UK currency will find it very difficult to retain this support if the UK slides towards recession, especially as any global weakness would put huge pressures on the already vulnerable banking sector. The burden of bad debts would continue to increase and make it even more difficult for the banks to expand lending.

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