The British pound took a hit Tuesday after official figures showed the U.K. economy unexpectedly contracted in the last three months of 2010.
Stocks in Europe and on Wall Street fell, although a surprisingly big rise in U.S. consumer confidence in January helped limit the losses.
In the U.K., statisticians largely blamed the 0.5 percent quarterly decline in output on heavy snow during December. They said output would have been flat without weather-related factors — still far below market expectations for a 0.5 percent increase.
Analysts said the figures have reined in expectations that the Bank of England would start raising interest rates soon in light of stubbornly high inflation levels — recent data 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 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 late afternoon London time, it was down 1.1 percent on the day at $1.58, off its earlier low of $1.5753.
Stocks were also hurt by the news, with the FTSE 100 index of leading British shares closing 0.4 percent lower at 5,917.71. Germany's main DAX index was down 0.1 percent at 7,059.01 while France's CAC-40 fell 0.3 percent to 4,019.62.
All eyes will be on Bank of England governor Mervyn King later Tuesday 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 is that Britain's economy is vulnerable to fiscal tightening. The raft of spending cuts and tax increases the government announced last fall had not yet come into force during the fourth quarter.
The markets are also getting ready for the U.S. Federal Reserve's first interest rate decision of the year Wednesday.
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 subdued at the bell after disappointing earnings from the likes of Johnson & Johnson and U.S. Steel. However, the selling was kept in check by a much bigger than anticipated jump in U.S. consumer confidence, as measured by the Conference Board.
Its main confidence index spiked to an eight-month high of 60.6 in January from 53.3 in December. The increase was far greater than the market consensus for a single point gain.
The Dow Jones industrial average was down 0.3 percent at 11,947 around midday New York time while the broader Standard & Poor's 500 futures fell 0.3 percent to 1,287.18.
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 and Australia's S&P/ASX 200 gained 0.5 percent. Hong Kong's Hang Seng index dropped less than 0.1 percent while shares on mainland China were down as investors continued to worry about attempts by the government to slow growth and get inflation under control.
The Shanghai Composite Index fell 0.7 percent and the Shenzhen Composite Index for China's smaller, second market was down 1.2 percent.
Among currencies, the euro was down 0.3 percent at $1.3595 having hit a two-month high on Monday. The dollar was 0.2 percent lower at 82.38 yen.
Benchmark crude for March delivery was down $1.15 at $86.72 a barrel in electronic trading on the New York Mercantile Exchange.
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