Pound-Euro Set Lower after PMI Highlights Divergence of UK and Eurozone Economies

  • Eurozone to avoid recession say economists
  • But the UK is in economic recession
  • This according to latest PMIs
  • Bank of England can soon stop rate hikes
  • Weighing on GBP/EUR

Image © Adobe Stock.

The UK economic downturn is still underway whereas the Eurozone appears to have turned a corner; developments that are tipped by currency analysts to weigh on the Pound to Euro exchange rate (GBP/EUR).

Pound Sterling fell against its continental peer after survey data for January revealed a noticeable divergence in performance between the UK and Eurozone economies and investors accordingly reassessed their expectations for the path of interest rates.

"The UK faces slightly stiffer economic challenges currently than the Eurozone. How the BoE and the ECB navigate the months ahead will likely determine how the EUR and GBP perform," says Thomas Flury, Strategist at UBS AG's Chief Investment Office.

The Eurozone Composite PMI exited contraction territory in January after reading at 50.2 from 49.3 in December, beating expectations for 49.8.

"This is the highest reading since June and suggests that downside risks are receding," says Tullia Bucco, Economist at UniCredit Bank.

By contrast, the UK Composite PMI read at 47.8, down on December's 49 and below analyst forecasts for 49.1.

"January’s flash PMIs suggest that GDP still is on a downward trend, as real incomes continue to fall in response to a pullback in government grants in Q1, increases in interest rates, and the commencement of job cuts," says Gabriella Dickens, Senior UK Economist at Pantheon Macroeconomics.

GBP/EUR slipped to 1.1314 in the wake of the figures and short-term momentum suggests a test of January lows at 1.1250 cannot be discounted over the coming days.

Pantheon Macroeconomics says the PMI survey is consistent with its forecast for UK GDP to fall by 0.3% quarter-on-quarter in the first quarter of 2023 and by a further 0.6% in the second quarter.

"Amid tightening financial conditions and despondent consumers in addition to the gas supply shock, the UK will likely suffer a harsher recession than mainland Europe," says Salomon Fiedler, an economist at Berenberg Bank.

Economists are meanwhile lifting their projections for the Eurozone economy amidst falling gas prices and better-than-expected data prints. "Our economists now no longer see a Euro area recession in 2023 that had informed our downbeat view on the common currency last year," says Patrick R Locke, a strategist at JP Morgan.

The differing PMI outcomes open up a relatively sizeable economic performance gap between the two regions and could suggest the European Central Bank (ECB) is poised to hike interest rates at a faster rate than the Bank of England, supporting the Euro at the expense of the Pound.

"Fading recession fears, firms' strong pricing power and a tight labor market will the keep the ECB on a steep tightening path. Next week, we expect another 50bp hike and hawkish rhetoric consistent with a peak deposit rate in the 3.50% area," says Bucco.

The PMI data meanwhile afford the Bank of England a window within which to consider exiting the interest rate hiking cycle and therefore raises the prospect of a 25 basis point hike on February 02.

Heading into this week markets were poised for a 50 basis point hike as official data out last week showed elevated wage increases and strong core inflation consistent with a need for the Bank to go further.

GBP/EUR 4 hour intervals

Above: GBP/EUR at four-hour intervals. Consider setting a free FX rate alert here to better time your payment requirements.

But Dickens says "the silver lining to S&P’s survey, however, is that it strengthens the case for the MPC to stop hiking Bank Rate soon."

She says the employment balance component of the PMI report remains below the 50.0 mark in January, despite edging up to 49.8, from 49.3 in December, as firms continued to respond to the sharp increase in their financing costs.

According to Dickens, this is consistent with the number of private-sector jobs dropping by around 0.3% quarter-on-quarter in the first quarter.

While the Eurozone is already in recovery mode the UK economy will have to wait until the second half of this year before activity starts to recover, she adds.

"Beyond the continuing fallout from Brexit, the UK now lags behind the Eurozone because its economy is more exposed to the rise in interest rates and its fiscal policy is turning contractionary," says Berenberg's Fiedler.

UBS is forecasting the Euro to outperform the Pound over much of 2023 in response to evolving economic dynamics. "A more hawkish ECB than BoE leads to modest upside for the EUR," says Flury.