EUR GBP - FUNDAMENTAL ANALYSISCurrency Markets on UK Recession Watch - There has been high volatility in the Pound to Euro (GBP/EUR) exchange rate during the past week.
GBP/EUR posted a fresh 9-month best conversion at 1.1735 early in the week before a slide to below 1.1600 after the Bank of England (BoE) policy decision.
Weaker than-expected Euro-Zone data helped strengthen GBP/EUR to 1.1700 on Friday.
Both the ECB and Bank of England will want to maintain a hawkish policy stance. Evidence on economic strength is likely to be a key element in the short term.
Aggressive BoE Action to Fight Inflation
The latest UK inflation data recorded an unchanged headline rate of 8.7% while the core rate increased to 7.1% from 6.8%.
The Bank of England (BoE) increased interest rates by 50 basis points to 5.0% this week as it looks to bring inflation under control.
The UK 2-year yield has increased to a fresh 15-year high of 5.15%.
Following the BoE move, investment banks have raised their rate forecasts.
JP Morgan, for example, now expects that rates will be increased to 5.75%.
The bank added; “This new policy rate level in our forecast recognizes that there is a dynamic between wage and prices that needs to be stopped and assumes the BoE will need to hike further in order to trigger a significant weakening in the labour market.”
High yields will provide an element of support to the Pound, especially with short-term yields comfortably above longer-term rates.
According to ING; “From a currency perspective, a sharply inverted yield curve can work as a positive factor for a reserve currency like the pound (as opposed to growth-sensitive currencies). We suspect that a rebound to 0.88 in EUR/GBP(1.1360 for GBP/EUR) will need to be delayed on the back of that.”
Commerzbank is still not confident that the BoE has got a grip on inflation.
According to the bank; “So the impression remains of a central bank that was too slow in starting to hike its key rate and moved to smaller rate steps too early, even signalling a possible pause. The BoE seems to be chasing inflation developments rather than fighting them with an active monetary policy, which is damaging for Sterling.
It added; “As we do not believe that the BoE will suddenly take a different approach, we remain sceptical for Sterling.”
UK Economic Fears Liable to Increase
The latest UK PMI business confidence data recorded a decline in the manufacturing index to a 6-month low of 46.2 for June from 47.1 previously and below consensus forecasts of 46.8.
The services-sector index also retreated to a 3-month low of 53.7 from 55.2 and below expectations of 54.8.
Chris Williamson, Chief Business Economist at S&P Global Market Intelligence commented; “while the June survey reveals the economy to be cooling as a result of higher interest rates, the stubbornly elevated price growth in the service sector suggests the Bank of England will consider its fight against inflation as still a work in progress. However, such rate hikes will clearly add further to the likelihood of a recession later in the year, which is looking increasingly inevitable as collateral damage in the fight against inflation.”
According to TD Securities; “Rates are reaching a point where they will have a negative impact on growth, which is feeding back into a weaker currency.”
The bank expects that the economy will suffer; “We now expect three more 25 bps hikes in Bank Rate, taking it to 5.75% in November. As policy tightening catches up to the real economy, a recession is likely to emerge this winter, with cuts coming in Bank Rate from February 2024.”
It adds; “The 50 bps hike plays well into our EUR/GBP topside view, where we could see a push towards the top-end of the recent range back near 0.89 in the months ahead.” (1.1235 for GBP/EUR).
Euro-Zone Unease Intensifies
The latest Euro-Zone PMI business confidence data recorded a decline in the manufacturing index to a 37-month low of 43.6 for June from 44.8 the previous month and compared with an unchanged reading for the month.
The services-sector index also retreated to a 5-month low of 52.4 for the month from 55.1 previously and well below expectations of 54.5.
The data will reinforce near-term unease surrounding the Euro-Zone outlook.
At this stage, the ECB has maintained a hawkish policy stance and is expecting to increase interest rates further at the July policy meeting.
As Euro-Zone inflation declines, it is likely that the real interest rates will increase and potentially move into positive territory.
If UK inflation is stubborn, real UK rates will remain low and potentially negative.
In this context, Danske Bank notes;
“On balance, we continue to see relative rates as a positive for EUR/GBP from here, which is one of several reasons behind our fundamental predisposition of buying EUR/GBP dips. We highlight that whether the aggressive BoE market pricing will subside or inflation continues to surprise, we see it as headwinds for GBP.”
It has a 6-month GBP/EUR forecast of 1.1360.
Berenberg still has an end-2023 GBP/EUR forecast of 1.1765.
