UK economic activity declines as interest rates rises hit demand

According to a recent survey, the UK’s economic activity dropped unexpectedly for a first time since January as higher borrowing costs hit consumer demand. This prompted investors to reassess interest rate expectations and to buy gilts.

Investors lowered their forecasts of interest rates peaking below 6% after the August flash UK composite purchasing manager’s index. After a first sell-off, the sterling fell by 0.16 percent to $1.2714.

The PMI, which is a measure for the economy was 47.9 points in August. This was down from 50.8 points in July, and the figure fell below neutral 50 for the first since the beginning of the year.

A reading under 50 indicates that a majority of companies are reporting a contraction. August’s number was significantly below the 50.3 predicted by economists according to a Reuters survey.

Bank of England policymakers will scrutinize the figures when they decide whether to raise interest rates next month for the 15th time in a row since December 2021. The benchmark rate of the central bank is now at 5.25 percent, which is a 15-year record.

Capital Economics economist Paul Dales said that the data will encourage the BoE to “raise rates” and soon GDP would contract, triggering a “mild recession”.

The UK government bond market recorded its biggest daily price gain since March’s collapse of Silicon Valley Bank. This is an indication that markets believe interest rates won’t rise as much as they previously believed. The 10-year gilt yields fell by 0.18 percentage points as investors bought bonds. These yields move in the opposite direction to bond prices.

Swap market pricing now projects a benchmark interest rate of the BoE at 5,8 percent, a peak less than 6 percent by early next year.

Dales said that the PMI data showed “dual signs” of a weakening economy and an easing in price pressures. This strengthened his belief that rates will “peak at around 5.5 percent rather than the 6 percent that was priced into the market before this release”.

Chris Williamson said that a new economic contraction was “already inevitable” as a more severe manufacturing downturn was accompanied by a further faltering of spring’s revival in the service sector.

He calculated the survey as indicating a decline in gross domestic product of 0.2 percent over the third quarter.

Jordan Rochester, an exchange strategist with Nomura, expects that the pound will weaken even further, to $1.22, by October. He said that the Bank of England will be hesitant to increase interest rates if these numbers are repeated. “We were at this PMI level last October, when energy prices were very high.”

Martin Beck, Chief Economic Advisor of the EY Item Club consultancy, stated that the data confirmed his impression, “that, if a rate increase occurs next month, it will probably be the last for the current cycle”.

He cautioned that the findings “may be insufficient to prevent the Bank of England [from raising interest rates] in September, given recent developments of pay and service inflation”.

These figures are a result of more robust economic data, which includes better than expected statistics on public lending as well as growth in the second-quarter.

The survey of the PMI revealed that companies reported a decline in the number of orders placed for goods and services due to the rising cost-of-living crisis, increased borrowing costs, losses on exports and concerns over the economy outlook.

The services sector has contracted for the very first time since the beginning of the year, and the output is at its lowest level in 31 months. The manufacturing sector’s decline accelerated and marked the sixth consecutive month with falling output.

Based on interviews conducted between August 10 and 21, the survey found that input costs increased at their slowest rate in two-and-a half years while the average price charged by the private sector rose at its lowest rate since February 20,21.

The BoE will welcome a weaker demand after official data revealed that regular wages rose at the fastest rate in history during the three-month period ending June. This indicated persistently high price pressure.

Employment growth slowed between July and august, the lowest rate since March. However, survey respondents noted that they continue to have difficulty in retaining and recruiting skilled workers.

The deteriorating performance in the UK has been mirrored by the eurozone where the composite PMI index dropped to a low of 47, a 33-month record.