Fundamental Outlook for British Pound: Bearish

- U.K. 1Q GDP Contracted By 2.4% as the final reading was revised lower from the preliminary -1.9%
- The June U.K. manufacturing PMI reading rose to 47.0 from 45.4, which was the highest since May 2008
- UK PMI Services fell in June to 51.5 from 51.7, diming recovery hopes

The British Pound was derailed mid-week by a larger than expected contraction in 1Q GDP of 2.4% which saw the GBP/USD fall over 400 pips from its high of 1.6746. A dismal US NFP report also added to bearish sentiment as it sparked broad based risk aversion. Sterling had shot higher to start the week after Nationwide showed house prices gained 0.9% in June which spurred hope that the housing sector stabilization would lead the way to a recovery. However, the depth of the first quarter contraction was a wake up call for forex traders as they realized that he country would need to dig itself out of a deep hole before consistent growth would return. Although, we saw manufacturing reach its highest level since May 2008 at 47.0, it remained below the 50 boom/bust level for the fifteenth consecutive month. Adding to the bearish sentiment was the service sector regressing to 51.5 from 51.7, which accounts for 70% of GDP. Nevertheless, the sector remained in expansion territory which is something that Pound bulls can hang their hat on and may allow the BoE to remain to refrain from further measures.

The BoE’s quarterly credit conditions survey showed that credit to households in the first quarter rose which may help spur domestic growth and help offset the declining demand for U.K. exports. However, going forward the BoE said "Over the next three months household demand for secured credit was expected to remain broadly unchanged while demand from small businesses was expected to pick up." Indeed, the bank showed in its equity withdrawal report that Britons are becoming fiscally responsible in the current crisis as they paid down their mortgage debt at a record pace. Individuals added to their housing equity for a fourth quarter, paying in a net 8.1 billion pounds ($13.2 billion), which was the most since records began in 1970. In the long run this will benefit the U.K. economy but over the near-term it will equal less demand for higher ticket items such as cars and vacations which could limit the scope of a recovery. New BoE member David Miles in his first statements said that economic growth would be anemic and that the banking system=m was still “on life support”.

The upcoming Bank of England rate decision could be the major event risk for the week if we see the central bank issue a statement addressing its future intensions regarding quantitative easing. It is widely expected that hey will leave their benchmark rate at 0.50% with signs that downside risks remain for the economy. However, traders will be looking to see if they add to their bond purchases beyond the £125 billion currently earmarked. This past week saw the bank leave off two gilts from its purchases leading to speculation that it will finish its purchases at the end of the month. Indeed, the government's unprecedented high borrowing levels to fund a bail-out of the banking sector and pull Britain out of recession have led to fears it will be many years before the public finances are returned to a more stable position. Some believe the next step for the BoE is to develop a plan to unwind its quantitative easing policy. However, MPC member Tim Besley said this week that 'there is no sense in which there is a specific timing discussion,' when asked about QE and how to get out of the policy.

Manufacturing, consumer confidence and inflation data this week will provide insights into the state of the U.K. economy and the scope of a recovery. Slower output growth and declining prices will add to the bearish outlook that is beginning to form, while a increase in consume confidence will give hope that a return of domestic growth is around the corner. Additionally, the Visible Trade Balance report will show us that state of demand for British goods. The GBP/USD has broken below the 20-Day SMA which it hadn’t closed below since 4/29 adding to the signs that we may see continued losses for sterling this week. However, improving fundamental data and a positive BoE could put pound bulls back in the driver seat.

DailyFX provides forex news on the economic reports and political events that influence the forex market.