Pound slumps on rate hike blow

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Traders' hopes for a UK rate hike were dealt a blow on Wednesday after disappointing manufacturing data posed serious questions over the strength of the recovery.

Sterling slumped across the board following the data release, which showed May manufacturing PMI at 52.1 below expectations for a reading of 54.1.

The pound fell 0.26% on the dollar and 0.32% against the euro to sit at 1.6405 and 1.1388 respectively by 10.30 BST.

Richard Driver, currency analyst at CaxtonFX, said: "Sterling has taken a major hit in response to today's manufacturing sector data, dropping by almost a cent against the US dollar and by half a cent against the euro. All this does is place further doubts over the strength of the UK's economic recovery, which pushes back expectations of a long-awaited Bank of England rate rise."

The 20-month low in manufacturing activity during May was chiefly driven by a slump in the output balance from 56.3 to 49.9, which tipped it just into contraction territory.

Jonathan Granby, researcher at DailyFX, said if this trend is repeated in the construction and service sector PMIs released on Thursday and Friday, the hawks on the Monetary Policy Committee could switch sides.

The two remaining hawks, Martin Weale and Spencer Dale, are said to be "data dependent" and admitted their votes at the last interest rate meeting were "finely balanced".

Granby said: "Any movement by the hawks back toward the majority [dove] group on the MPC will only serve to push any rate action deeper into the second half of 2011 as UK growth worries remain at the fore of the central banks' concerns. The pound took a nosedive in the aftermath of the soggy PMI manufacturing release as anyone betting on action from the Bank of England immediately had to rethink their timetable."

He added further setbacks could be seen if sentiment turns fully against the pound, and future gains for the pound are likely to be a reflection of dollar or euro weakness, rather than sterling strength.

The marked slowdown in manufacturing activity was also experienced in Europe, with Eurozone PMI manufacturing data posting a seven-month low of 54.6 in May, down from 58 in April and from a peak of 59 in February.

Howard Archer, chief European and UK economist at IHS Global Insight, said: "This suggests the global manufacturing rebound from the sharp drop in output suffered during the 2008/9 recession is now running out of breath. This may well be influenced by inventory rebuilding having now largely run its course as well as slowing demand."

Another worry is the knock-on effect weaker PMI data could have on second-quarter GDP. In April, surprisingly firm UK retail sales raised hopes GDP in the second quarter would be better than expected, but this is now looking less likely.

Andrew Goodwin, senior economic advisor to the Ernst & Young ITEM Club, said: "There was never any prospect of a move in interest rates next week, but these results make any move this year that much more unlikely. With some major question marks emerging over the state of the recovery, it is difficult to see the MPC feeling certain enough about future prospects to contemplate a rise in rates any time soon."

Driver concluded: "Almost every time the UK economy comes into focus, sterling suffers a decline. The eurozone debt crisis has taken a good deal of heat off the pound in the past month, but circumstances in the UK are still seriously shaky."

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