GBP/EUR Rate: ECB Day Targets

File image of ECB President Christine Lagarde. European Central Bank.

The British Pound has come under pressure against the Euro in May as investors bet Thursday's European Central Bank (ECB) interest rate decision and guidance will see it maintain its crown as the most hawkish of the major central banks.

Money market pricing shows investors are poised for 30 basis points of hikes at the ECB, which in effect means the market is split on whether it will deliver a 25 basis point move or 50bp.

The former could result in knee-jerk Euro weakness, the latter in Euro strength. "Markets still under-price the risks of a 50bps hike," says James Rossiter, Head of Global Macro Strategy at TD Securities.

"Bias skews in favour of EUR upside, especially if the ECB surprises with a 50bp hike," says Rossiter.

The Pound to Euro exchange rate, with a test of sub-13 levels being possible under such a scenario.

But, as always, the enduring foreign exchange reaction will most likely be decided by the guidance as to where rates are heading: is there one more hike left in the tank or more?

The tone and language used by ECB President Lagarde will be closely watched as the central bank will be keen to ensure the market doesn't get ahead of itself and price for rate cuts prematurely. Such a development would result in easing monetary conditions in the Eurozone at a time when inflation levels remain elevated.

Such a development would result in easing monetary conditions in the Eurozone at a time when inflation levels remain elevated.

Therefore guidance for further rate hikes will be likely with the ECB saying inflation remains too high and it continues to watch the data when determining how much further to hike.

Above: GBP/EUR trades a well-worn range. (Consider setting a free FX rate alert to better time your payment requirements, please see here.)

The Euro is one of the better-performing major currencies of 2023 as investors react with relief to rapidly falling European gas prices and signs of robust economic growth and inflation.

Rising inflation has seen investors lay bets that the ECB can hike by more than many of its major peers over the coming months, underscoring a strong bid for the Euro.

"With inflation set to decline only very gradually from now on, and underlying pressures clearly remain elevated – which also increase the risks of second-round effects on upcoming wage negotiations, considering the very tight labour market – we still see a risk that the ECB might hike for a little longer," says Fabio Balboni, Senior Economist at HSBC Bank plc.

Nevertheless, data shows investor positioning is now 'long' the Euro, which leaves it at risk of a setback if the ECB disappoints with a more cautious message.

In fact, the bar is now set high for the ECB to push already hawkish expectations even further, which means a retracement lower in the Euro is quite possible.

This suggests a move higher in Pound-Euro back to 1.14 is not entirely out of the question. "EUR positioning sits long, suggesting a more muted response. We would use any washouts to re-buy dips," says Rossiter.

Economists at HSBC expect the ECB to hike in May and June and then pause as this week's inflation data showed core inflation might finally be moderating in the face of rising interest rates.

Core inflation, which is important to the ECB's thinking as it excludes energy, food and regulated price items from the goods basket, edged down from 5.7% to 5.6% last month.

"The ECB should continue on a tightening path for a few more meetings, albeit likely at 25bp increments from here. Some loss of momentum notwithstanding, which allows for this step-down in the pace, underlying inflation remains too high against a backdrop of accelerating wage growth," says a note from Barclays.

Consumer demand in the Eurozone is also seen to be holding up remarkably well, aided by the sharp drop in energy prices and China's reopening, while ECB policy is yet to become overly restrictive.

As a result, foreign exchange strategists at Barclays say even a slowdown in the rate hiking cycle - i.e. a 25bp hike down from 50bp - is not an obstacle for more upside in the Euro; "any headwinds to the EUR from the slow-down in the pace of hikes will be temporary in our view."

However, analysts at Barclays say Pound-Euro downside is likely to be limited as the Bank of England is expected to maintain vigilance against upticks in inflation.

The Bank of England will deliver its latest interest rate decision and Monetary Policy Report a week after the ECB on May 11. Another 25bp hike is expected with potential growth and inflation upgrades being announced by Bank economists.

"Although the bar is now too high for the MPC to take a more hawkish position than the market, high and sticky domestic inflation along with strong wage growth are transforming the BoE into a less-dovish central bank versus G10 peers. This leaves sterling range-bound around current levels versus the euro," says Barclays.

The Bank of England would therefore likely retain guidance that it remains data-dependent, something that should allow Pound exchange rates to maintain recent levels.

Pound-Euro has risen for four months in succession, but the gains have been scarcely believable: 0.36% in January, 0.25% in February, 0.07% in March and 0.26% in April as both currencies are effectively deadlocked.

This is because both the Pound and Euro both benefit from falling gas prices with UK month-ahead natural gas now near £80/therm, putting it at levels last seen in the summer of 2021.

For now, the economic renaissance story is applied equally to both currencies and it will take a significant turn in the data, or idiosyncratic events, to drive a breakout.

The 1.1270-1.14 region is heavily favoured and any moves on either side look set to be faded.