The pound has been the beneficiary of two critical trends. First, economic data over the past few months has been relatively stable, with business activity in the third quarter enjoying a rebound. In fact, the latest GDP reading released yesterday showed that the UK economy grew at 0.5 per cent, versus a 0.3 per cent forecast. Secondly, UK debt has been afforded a remarkable measure of respect in the credit market. The standard five year CDS contract costs only 91 basis points for UK – less than the much larger and arguably much more stable German economy, which was trading at 97 basis points. Contrast that with the 513 basis points that the market now charges for Italian debt and the question that you must ask is – is UK credit really five times as safe as Italian credit?
I believe the answer is no. The UK economy remains laden with debt and is still very heavily reliant on the finance sector for growth. Furthermore, the latest economic data is signalling another stall in activity. Yesterday’s massive miss in the PMI Manufacturing report, which printed at 47.7 versus 50 eyed, caused a sell-off in cable, as traders were more concerned about decline in forward demand than the backward leaning GDP surprise. Therefore, this Thursday’s PMI Services report could be the tipping point for the pound. If the data prints below 50, signalling contraction in the critically important services sector, investor attitudes towards sterling could change in a heartbeat, as the rosy credit assumptions and growth prospects are challenged – threatening to send the pair to $1.50 by year end.