GBP/EUR: Downside Likely Limited from Here says HSBC Strategist

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The British Pound's retreat from July highs against the Euro and Dollar could slow from here with one analyst saying the Bank of England's August policy decision and guidance had enough 'hawkish' elements to limit the prospect of further downside.

The Bank opted to raise rates by 25 basis points as it pulled back from June's outsized 50 basis point hike, in a decision that triggered a kneejerk selloff in the Pound to Euro exchange rate to 1.1552 as markets initially read the decision as being a 'dovish' one (i.e. the Bank is less intent on raising interest rates as was previously the case).

"The decision did represent a somewhat dovish outcome, but there were still some elements of hawkishness in the vote split, the statement, and the forecasts," says Dominic Bunning, Head of European FX Research at HSBC.

These elements include the two votes for a 50bp hike, by Catherine Mann and Jonathan Haskell, and the statement retaining the line that a "further tightening of monetary policy would be required" if there was evidence inflation was more persistent.

"On top of this, the BoE’s forecasts for inflation for 2025 increased compared to May’s monetary policy report, despite the new forecasts being predicated on higher rates than those used in May’s projections," says Bunning.

The Pound and UK bond yields fell in the days leading up to the Bank of England's August decision, reflecting the market's steady reduction in expectations for the peak in Bank Rate, which fell to just below 5.75% in the wake of the decision.

But expectations ultimately steadied as investors grasped the 'hawkish' elements of the day.

Governor Andrew Bailey was keen to point out in the post-decision press appearance that the strength of the labour market remains a factor that can keep inflationary rates elevated for an extended period.

"The committee also flagged how strong pay growth created an ongoing risk of persistent inflation. This suggests the BoE retains a modest tightening bias, especially compared to the more explicitly data-dependent Fed and ECB," notes Bunning.

"We have argued that GBP was looking stretched on the upside in mid-July and have expressed a tactically bearish view on the currency versus NOK in recent weeks. But some of the hawkish elements below the surface of today’s decision may limit excessive downside in the currency from here," he adds.

Above: The GBP/EUR fell and then recovered in the wake of the MPC decision.

A key takeaway amongst economists responding to the Bank's latest decision is that interest rates are unlikely to rise as high as expected by the market back in June (well above 6%) but they are likely to stay higher for longer, ensuring the market reduced expectations for rate cuts in 2024 as a result.

This is a development that has offered the Pound some support given foreign exchange markets are now looking forward to the rate-cutting cycle of the coming months and years.

"The BoE has said it is taking a different path to achieve the same end result, implying that the risk is for later and/or shallower cuts than we currently expect," says Matthew Swannell, Economist for Europe and UK at BNP Paribas.

"We had expected the first cut to fall in Q2 2024, and for Bank Rate to end next year at 4%, consistent with our view that cumulative tightening would push the economy into a shallow recession in H1 2024. We see risks to this view as skewed towards later and/or less deep cuts," he adds.

The Bank's statement said for the first time that monetary policy is now restrictive but that the Bank would hold policy restrictive for long enough to bring inflation down to target.

In addition, having recognised previous forecasting errors, the Bank raised its medium-term forecasts, which investors judged to be a development consistent with its 'higher for longer' message.

Taken together, the August Bank of England event is broadly supportive of the Pound given the numerous potential paths to further weakness that the event posed.