German economic contraction to extend in Q1 says BundesbankBut UK economy seen expanding approx. 0.2% q/qGrowth divergence can keep GBP/EUR supported

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The Pound to Euro exchange rate could hit new highs in the coming months as the German economy's contraction extends into 2024, just as the UK economy rebounds from recession.

Germany reported a contraction in the fourth quarter and Germany's central bank now says this decline will continue into the first quarter, marking an official recession.

German fourth-quarter GDP fell by a seasonally adjusted 0.3% on the quarter, according to the Federal Statistical Office's flash estimate, after virtually stagnating in the first three quarters of 2023.

Germany was 2024's worst-performing major economy, according to the IMF, and the Bundesbank says in a monthly economic assessment that "stress factors would probably remain in the first quarter", ensuring "economic output could therefore decline slightly again".

"Given the headwinds facing the German economy, we would favour looking to sell rallies in EUR/GBP in the coming months," says Jane Foley, Senior FX Strategist at Rabobank.

The Bundesbank said there were few signs of a rebound at the start of this year, saying: "With the second consecutive decline in economic output, the German economy would be in a technical recession."

"The loss of cheap Russian energy, soft demand from China, high interest rates and tighter labour markets have highlighted the need for structural reforms from the German government at a time when its budget position is strained," says Rabobank's Foley.

Rabobank says the weakness of German economic data adds weight to the argument that the pace of European Central Bank rate cuts could accelerate into 2025, potentially weighing on Euro exchange rates.

Above: German economic malaise can help GBP/EUR to break towards the upper end of the post-Brexit range, according to Rabobank. Track GBP with your own custom rate alerts. Set Up Here

The ongoing malaise in Germany will contrast with the UK, where data signals January witnessed an economic rebound, which means it will exit the recession it experienced in the final two quarters of 2023.

January's retail sales surged by 3.2% month-on-month, while PMI, business, and consumer confidence surveys all point to a strong start to the year.

"We’ve also seen evidence of green shoots in the housing market. The falls in house prices bottomed out in Q3 2023," says Ashley Webb, UK Economist at Capital Economics. "This isn’t to say that the economy is very strong, but it is turning in the right direction."

Capital Economics thinks composite activity PMI due for release this coming Thursday remained broadly unchanged in February at around 53.0 and will point to GDP growth of about 0.2% q/q in Q1.

Meanwhile, Germany is anticipated to report a composite PMI of 47.5, which is consistent with a contraction in activity.

Above: German PMI surveys point to an ongoing GDP decline in early 2024.

According to Rabobank, Germany's economic woes will eventually lead to further Euro weakness against Pound Sterling, resulting in a breakout from its recent range.

"EUR/GBP is currently positioned close to the bottom of its range. While we expect that the 0.85 level will offer strong support, we see scope for a break below in the latter part of this year, targeting 0.84 on a 6 to 12-month view," says Foley.

This would equate to a break above 2023 highs in Pound-Euro to 1.19.

The Pound-Euro exchange rate remains capped by the significant resistance at 1.1765, with last week witnessing yet another failure in this area.

The pair's subsequent pullback has nevertheless been shallow, and should it maintain levels around 1.17 over the coming days and weeks, the bulls will grow in confidence again and make a move for fresh highs.