UK Economy Contracts in 4Q

The UK economy met expectations and contracted in the fourth quarter. The drop in quarterly terms of 0.2% was a bit more than expected by economists (-0.1%) and did cause the pound to weaken against the US dollar and euro subsequently thereafter.

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However, the pound managed to reclaim most of its lost ground against the dollar and managed to gain on the day versus the euro as we worked our way through the New York morning.

Therefore this announcement while having some headline reaction seems to have been mainly priced into the market and the next key question is what will be next for the Bank of England - whether we should expect another round of quantitative easing or not.

If There's a Technical Recession, Will Likely Be a Shallow One

First however breaking down the details of the fourth quarter report we see that much of the softness came from a decline in factory orders as exports falter. That points to weakness from the UK's key trading partner - the euro zone.

From Financial Times: The primary source of negative news in the fourth quarter was the industrial sector, where weakness in the UK's key export markets is certain to have been a key factor, along with the unseasonably mild weather which depressed energy output...

The output of the nation's productive industries fell by 1.2 per cent. Manufacturing, which accounts for about 80 per cent of that, fell by 0.9 per cent, while utilities output contracted by 4.1 per cent, reflecting an unseasonably warm winter.

Separately, new data from the banking industry showed that lending to private, non-financial companies (PNFCs), after a slight pick-up in November, fell sharply in December.

On top of impacting exports and therefore causing a soft quarter for manufacturing, the euro zone crisis is also the main reason that's banks have been reluctant to lend and a main factor for business having poor confidence.

However with the European situation showing some sense of the normalcy - even though underneath it all crisis conditions remain - the first quarter of 2012 may have some hope of showing a rebound compared to the conditions we saw in the fourth quarter of 2011.

If the economy shows another month of contraction then UK would be in a technical recession, but if growth shows improvement then it may skirt a technical recession. But, even if growth is negative for another quarter the overall recession should be a shallow and short-lived one.

If we look at the forecast for the full year however the expectation is for tepid growth of about 0.7% which would follow a 0.9% growth rate in 2011 meaning that the year ahead will be a tough one.

A lot continues to ride on what happens in Europe and one sense of comfort was the recent PMI indicators from Europe which showed stabilization which is a positive backdrop for the UK.

However with rising unemployment, continued weakness in domestic demand, as well as softer exports to Europe, the prospect for a firm recovery in the first half of the isn't in the cards.

BOE Meeting Minutes and Expectations for QE

With the possibility of a shallow recession on hand the Bank of England may feel pressed to expand its purchase of bonds in its quantitative easing program. At the same time as the GDP data was released, the BOE posted its latest meeting minutes. They showed that the case for more quantitative easing was made, which is in line with what the BOE Governor Mervyn King is advocating.

From Bloomberg: For some members, the risks of undershooting the inflation target meant that a further expansion of asset purchases was likely to be required, the central bank said in the minutes of its Jan. 11-12 meeting published in London today. But there was no compelling need to increase the scale of the program before completing those already announced.

King said yesterday that slower inflation gives policy makers room to increase bond purchases to guard against a renewed severe downturn.

The language in the minutes compared with view among some MPC members in November and December that more so-called quantitative easing might well become warranted in due course.

From Financial Times: However, other members viewed the risks to inflation as more finely balanced and said it was less clear that inflation would fall below 2 per cent.

However, other members viewed the risks to inflation as more finely balanced and said it was less clear that inflation would fall below 2 per cent.

Market participants' expectation is that the BOE will in fact increase the scope of its bond buying program, the main question then is by how much. Will they use the same figure that we had back in October of £75 billion or choose a lower amount.

From The Telegraph: GEORGE BUCKLEY, DEUTSCHE BANK:

In terms of what it means for the Bank of England, there are two big bits of data which are going to be very important in terms of QE. One is today's GDP number which is supportive of more QE. The other is the PMIs. If they hold their own and stay at the December levels in January when they're published at the start of next month, that could easily see the Bank of England do a little bit less on QE than we currently expect.

We're currently saying 75 billion, they might want to do just 50, but I think we're looking at that kind of magnitude because these numbers are showing that the recovery is exceptionally slow.

Will GBP/USD Top Off, Or Will Recent 1-1/2 Week Rally Extend

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The drop in GDP growth could reinforce those on the BOE that want more stimulus and that could mean that the recent rally in that GBP/USD may find some fundamental factors for a retracement. In the 4-hour timeframe the RSI is showing a bearish divergence with price which could be indicative that technical factors may also line up to pressure the pair.

A failure of the pair to set a fresh high would be one indication that the bulls' momentum is running out, as would a move back below the 200-ema in this timeframe. We had reached that 1.5525 area following the GDP data but snapped back. A close on Wednesday or Thursday near those levels, and a subsequent break of the 200-ema would open up the downside case.

Therefore, while its still early to tell, the anticipation is that we could be in the early stages of a topping action and the remainder of the week will give us good clues as to what happens next.

Nick Nasad is the Chief Market Analyst at IBTrade and FXTimes  - provider of Forex News, Analysis, Education, Videos, Charts, and other trading resources.