July 25, 2012 / 11:18 AM / 5 years ago

Sterling falls as UK economy contracts sharply

* UK economy contracts 0.7 pct during Q2

* Data well below forecasts for 0.2 pct fall

* Pound slips, seen vulnerable to more losses

* Euro crisis means falls vs euro may be limited

By Jessica Mortimer

LONDON, July 25 (Reuters) - Sterling fell on Wednesday after data showed the UK economy contracted by 0.7 percent during the second quarter, its sharpest decline since early 2009 and more than three times the fall economists had expected.

Analysts said the pound could be vulnerable to more falls as the market starts to price in the prospect of further monetary easing by the Bank of England, either via more quantitative easing or a cut in interest rates.

The fall in gross domestic product was far steeper than the 0.2 percent drop expected and marked the third consecutive quarterly contraction in output.

“Going forward there is a risk that the situation in Europe continues to deteriorate, which will have a negative impact on the UK ... We could see the pound trading more negatively,” said Lee Hardman, currency economist at BTMU.

“The risks (for the data) were to the downside but the extent of the weakness was somewhat shocking,” he said, adding that he expected the pound to fall below $1.50 in the next 3-6 months.

However, sterling stayed close to a 3 1/2-year high against the euro hit on Monday. As fears grow about whether Spain will need a full bailout and whether Greece will leave the euro, many analysts expect sterling will still be scooped up by investors seeking alternatives to euro zone assets.

The euro was up 0.7 percent at 78.30 pence, having hit a 6-day high of 78.40 pence. This pulled it away from Monday’s trough of 77.56 pence, its weakest since late 2008.

Paul Robson, currency strategist at RBS, said the euro could squeeze higher against the pound if the market starts to price in an increasing probability of a cut in interest rates from their current record low 0.5 percent in the coming months.

“Valuations start to look a bit stretched this far below 80 pence.”

The pound fell to a 12-day low of $1.5469 before rebounding to $1.5505, helped by gains in the euro against the dollar.

More losses could see it target the July 12 trough of $1.5393.

The figures will intensify concerns the UK could struggle to meet its targets for cutting the deficit and prompted UK finance minister George Osborne to say the economy had “deep-rooted” problems.

The government’s determination to cut Britain’s debt through a programme of harsh austerity measures has broadly lifted the pound. However, economic weakness could put a dent in these plans as it offsets the benefits of spending cuts.

Offering a glimmer of hope after the weak GDP data, a survey pointed to resilience in the UK manufacturing sector, with factory orders stronger than expected in July, though sterling showed little reaction. (Editing by Nigel Stephenson)

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