British Pound Falls Against Euro Despite Robust Service PMI Data

Pound sterling has slipped back against the euro in mid-week trade even as survey data from the UK economy confirms the labour market is tightening to levels the Bank of England can no longer ignore.

Markit and the CIPS released their Service sector PMI data mid-week which came in below expectations but confirmed the labour market continues to tighten.

With the services sector accounting for well over 70% of then UK economy this data provides an important pulse into the strength of the UK economy.

The number that came in was 55.5, just below the forecast for 55.6. This miss has had a negative impact on sterling which softened against the dollar and saw the currency give up hard-fought new year gains against the euro.

The pound did however surge against the likes of the New Zealand and Australian dollars - but this is largely due to weakness in the said currencies.

Rather, of note to us, is the pound to euro exchange rate’s retreat. 2016 had gone well for GBPEUR and economic data out of the UK is certainly helping. The pair bounced off support at 1.35 and we had it tipped for a test of 1.37.

We believe that the pound sterling will move higher against the euro in January despite the mid-week decline.

What currency markets will take from the data is that the economy continues to provide the solid base for the British pound to advance in 2016.

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The current period of rising UK service sector output was extended to three years in December, as signalled by the Business Activity Index remaining above the no-change mark of 50.0.

The index fell slightly to 55.5, from 55.9 in November, but remained just above the long-run survey trend level of 55.2, indicative of solid overall growth.

"Services activity has been choppy in recent months, and as reflected by the PMI, output in the services industry is starting to show some deceleration toward 2% on a year-on-year basis. The fourth quarter’s PMI is consistent with GDP growth of about 0.5% q/q," says Paul Fage, Senior Emerging Markets Strategist at TD Securities.

Of note is that wage pressures continue to rise - something the Bank of England will pay close attention to when considering whether to raise interest rates in 2016.

“With increased business margins as a result of ongoing lower fuel and commodity prices, wages were up. Businesses tried to retain talented staff by rewarding good performance and continuing to increase capacity to meet further strong growth in new business,” says David Noble at the CIPS who co-author the data series.

According to Noble some respondents reported the enduring difficulty of finding skilled individuals when needed.

This suggests that economic slack is tightening considerably.

Remember, the Bank of England uses their gauge of economic slack as a key pointer when considering interest rate settings. The less slack, the higher the threat of inflation and hence a need to raise interest rates.

Rising interest rates translate into as stronger pound as international capital floods into the UK to take advantage of higher yields.

Pound Finds Support Against Euro, Struggles Against US Dollar

The pound has carved out a base to the December decline at around 1.35, we believe this area now comes in to form the spring-board to a January recovery / consolidation.

Granted, it will take some impressively good news to push the British pound back to levels around 1.42 and those watching the markets should keep their expectations in check as a result.

Meanwhile, the decline against the US dollar looks to be more well established.

"The long-term technical pattern is negative and favours a further decline towards the key support at 1.4231 as long as prices remain below the resistance at 1.5340/64 (04/11/2015 low see also the 200 day moving average)," says Yann Quelenn at Swissquote Bank.

Charles Purdy at Smart Currency Business pounts out that, "against the US dollar the trend is one of weakness and if the trend continues, which seems highly possible, we could soon be seeing levels for sterling against the US dollar last seen over five years ago."

That said, there is a sliver of hope for sterling bulls:

"However, the general oversold conditions and the recent pick-up in buying interest pave the way for a rebound," says Quelenn.