Pound takes a battering after shock UK contraction

[January 25, 2011]  LONDON (AP) -- The British pound took a battering Tuesday after official figures showed the U.K. economy unexpectedly contracted in the last three months of 2010.

Stock markets fluctuated -- though London indexes dropped -- as investors weighed improvements in Europe's debt crisis against fears that, as in Britain, economic recovery will prove fragile.

Though official U.K. statisticians said the 0.5 percent quarterly decline was largely due to heavy snow during December, they said that output would have been only flat without weather-related factors. Even an unchanged reading would have been far below market expectations for a 0.5 percent output increase.

Analysts said the figures have sharply reined in expectations that the Bank of England would start raising interest rates soon in light of stubbornly high inflation levels -- recent figures for December showed that consumer price inflation stood at 3.7 percent, way ahead of the Bank's target of 2 percent.

Unsurprisingly, the pound was hit hard following the figures as investors priced in a lower probability of an interest rate increase from the current record low of 0.5 percent.

Within a minute or two of the data's release, the pound had dropped over a cent against the U.S. dollar. By mid morning London time, it was down 1.3 percent on the day at $1.5771, while the euro was 0.9 percent higher at 0.8615 British pound.

Stocks have hardly been helped by the news and the FTSE 100 index of leading British shares underperformed its peers, trading 0.6 percent lower at 5,908.68. Germany's main DAX index was up 0.1 percent at 7.76 while France's CAC-40 was steady at 4,031.

All eyes will be on Bank of England governor Mervyn King when he delivers one of his few set-piece speeches of the year. Before the GDP figures, a number of analysts had been expecting the governor to present a more hawkish stance in light of the recent spike in inflation.

"An interest rate hike could be the nail in the coffin for any notion of a durable economic recovery this year," said Neil MacKinnon, global macro strategist at VTB Capital.

The concern in the markets now is that Britain's economy is extremely vulnerable to the current fiscal tightening. The raft of spending cuts and tax increases that the government announced last autumn had not even come into force during the fourth quarter.

As well as the British interest rate outlook, the markets are getting ready for the U.S. Federal Reserve's first interest rate meeting of the year.

The Fed is not expected to alter its current monetary stance, with the main interest rate at the record low of near zero percent and the central bank in the middle of a $600 billion injection into the U.S. economy.

However, investors will be looking for any noticeable change in views on the rate-setting Federal Open Market Committee following a slight improvement in economic indicators.

The difference between the Fed and the Bank of England is that the U.S. central bank has a dual mandate. As well as monitoring inflation it has to keep an eye on employment levels and so far the figures have not shown a noticeable improvement in job creation.

"While the recovery in GDP growth is encouraging, and the new fiscal policy stimulus negotiated by President Obama and the Republicans should provide further support, it may take considerable time before the unemployment rate is brought down to acceptable levels," said Philip Morey, an analyst at Rabobank International.

U.S. stocks were heading for a subdued opening. Dow futures were down 28 points at 11,902 while the broader Standard & Poor's 500 futures fell 4.6 points to 1,283.90.

Earlier in Asia, Japan's Nikkei 225 stock average added 1.2 percent to close at 10,464.42 after the Bank of Japan kept its key interest rate unchanged at virtually zero, hoping to protect a still-fragile economy from veering off track.

South Korea's Kospi rose 0.2 percent to 2,086.67 while Australia's S&P/ASX 200 gained 0.5 percent to 4,807.80. Sentiment was bolstered by the country's latest inflation reading, which fell below expectations and reduced the chances of a rate hike by the Australian central bank.

Hong Kong's Hang Seng index dropped less than 0.1 percent to 23,788.83 while shares on mainland China were down as investors continued to worry about further attempts by the government to slow growth as it tries to get inflation under control.

The Shanghai Composite Index fell 0.7 percent to 2,677.43 and the Shenzhen Composite Index for China's smaller, second market was down 1.2 percent to 1,136.58.

Aside from developments surrounding the pound, there was little action in the currency markets. The euro was down 0.3 percent at $1.3595 having hit a two-month high on Monday,.

The dollar meanwhile was 0.2 percent lower at 82.38 yen.

Benchmark crude for March delivery was down 21 cents at $87.66 a barrel in electronic trading on the New York Mercantile Exchange.

[Associated Press; By PAN PYLAS]

Pamela Sampson in Bangkok contributed to this report.

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