Sterling shines as UK growth prospects brighten

Highlights:

Strong European PMI figures allay growth fears, boosting sterling and the euro.

US economy slows in Q1, but high inflation suggests delayed start to Fed cuts.

Japanese yen sinks to fresh three-decade lows, before rebounding on suspected FX intervention.

AUD outperforms as hot Australian inflation data hints at more RBA rate hikes.

The PMIs are the best leading indicator we have for European economies, and last week’s releases pointed to quickly improving growth prospects, notably in the service sector.

The UK numbers, in particular, surprised to the upside and the composite index is now consistent with quite strong growth, which is taking place in an economy already at full employment. Unsurprisingly, sterling rose sharply against every other G10 currency, save the Australian dollar. The week’s loser was the Japanese yen, which fell more than 2% as the Bank of Japan appeared unconcerned with a currency that is plumbing depths not seen since the early 80s in nominal terms, and not since the 60s in inflation-adjusted terms.

The latter half of this week is packed with data and central bank events. We start on Tuesday with the Eurozone’s advance first quarter growth report. Then, on Wednesday, the Federal Reserve holds its May meeting, where markets expect a ratification that a June cut is off the cards. We’ll then see the Eurozone’s flash CPI report for April on Thursday, and we will round off the week with the publication of the US April payrolls report on Friday.

USD

The US first quarter GDP report was everything the Federal Reserve did not want to see. In addition to surprisingly strong inflationary pressures, strong domestic demand was offset by a dismal trade performance, a sign that dollar overvaluation is hurting US competitiveness.

The FOMC meeting on Wednesday will be a difficult test for Chair Powell’s communication skills. While the June cut has been effectively ruled out both by markets and Fed communications, there will be questions about the appropriateness of any cuts at all, and even the possibility of further tightening in view of rebounding inflation pressures. The US dollar has already rallied hard and may have difficulty going up any further unless outright hikes begin to be priced in, which we do not expect unless inflation continues to surprise on the upside.

EUR

The healthy rebound in the April PMIs of business activity underscores the positive trend in Eurozone growth, after it barely avoided a technical recession in the latter half of 2023. It bears noting that the overall number displays an extreme dichotomy between the industrial sector, which is falling deeper into recession, and a healthy expansion of the services sector, no doubt helped along by an economy in full employment and healthy household balance sheets.

The positive surprise does not seem sufficient to derail the ECB’s commitment to a June interest rate cut. However, any subsequent moves will be conditional on a continuation of the decoupling between US and Eurozone inflation. This decoupling will be tested this week when the critical April flash inflation report is released on Thursday.

GBP

The significant positive surprise in the April PMI report makes it even less likely that the Bank of England will be able to cut UK rates before September. Britain’s composite PMI jumped to its highest level in almost a year this month, and is now well above the level of 50 that denotes expansion. Not only is last year’s technical recession likely to prove both shallow and short, but a decent rebound in growth appears on the cards in the second quarter of the year.

The booming services sector contrasts with an industrial sector that is still in recession, but it is in services where inflationary dangers continue to lurk in the UK. An expanding economy in a context of full employment and lingering inflationary pressures are likely to keep UK rates relatively high, and we expect the recent grind higher in the pound to continue. Swap markets are still pricing in a first BoE rate reduction in August, but a gradual pace of cuts is seen through the rest of the year.