"Overbought" Pound-Euro Rate Dips Below 1.15, but Citi says Can Still go Higher

- GBP/EUR pares recent advance
- Rising EUR/USD exerts pressure
- Citi say they retain bullish stance on GBP/EUR

Image © Pound Sterling Live

• GBP/EUR spot at publication: 1.1458
• Bank transfer rates (indicative guide): 1.1157-1.1237
• Money transfer specialist rates (indicative): 1.1309-1.1378
• More information on bank beating money transfer rates, here

The British Pound has recorded its first daily loss against the Euro in two weeks after a strong rebound in the Eurozone's single currency, although analysts at Citibank say they maintain a preference for Sterling upside.

The Pound-to-Euro exchange rate fell below the 1.15 mark to quote at 1.1458 ahead of the weekend following a 1.00% decline on Thursday and a further 0.40% loss ahead of the weekend.

Pound Sterling's losses coincide with a rally of half a percent in the Euro-Dollar exchange rate.

The Euro is on the front foot with advances being recorded against all of the G10 complex apart from the two Scandinavian currencies:

Above: The Euro has seen strong gains in the past 24 hours.

"There were no real headlines to trigger this move, though we have seen constructive flow dynamics," says Rui Ding, a foreign exchange analyst at Citibank.

Citi are the world's largest prime dealers of foreign exchange and are therefore have the privilege of seeing where currency demand and supply is originating.

Ding says the move higher in the Euro originally started with Euro/Emerging Market exchange rates moving higher. "We saw real money and European corporates buying," he adds.

Citi's eTrading desk reports Euro-Dollar trading volumes were 70% above the 30-day average during the London morning session and that there has been corporate and leveraged buying of the Euro too, with banks selling.

The rally in the Euro coincides with a sharp jump in the yield paid on German bonds with a ten year duration, a move that reflected a broader investor focus on developments in global bond markets and inflation expectations.

"Big move higher for the Euro," says Erik Bregar, Head of FX Strategy at Exchange Bank of Canada. "Felt flow driven with the market going bid against everything else on no news, at the same time... Bund yield rallies above -0.28% to new swing highs."

Yields paid on two-year bonds increased by 2.8 basis points and the yield on the ten-year rose 6.1 basis points.

"The German 10-yr yield moved above the -0.26% May top which was the final hurdle before the -0.14% 2020 high," says Mathias Van der Jeugt, an analyst at KBC Markets.

"The single currency outperforms amongst FX majors," he adds.

Above: The rise in ten year bond yields (blue) and the rise in EUR/GBP (orange).

It is worth noting that the rise in ten year German bond yields has not really been a factor for EUR/GBP considerations of late and that the relationship has only really turned positive on Thursday.

Therefore, it is too soon to say whether this is a factor to consider going forward.

What is however important is that markets have started pulling forward bets on when an European Central Bank (ECB) rate hike might happen, with Van der Jeugt noting a 0.25% rate hike is currently seen coming in the second half of 2024.

The general rule of thumb in foreign exchange is that when expectations rise for a central bank to raise interest rates, the currency it issues appreciates in value.

Why are the yields on ten-year bonds and expectations for a rate hike at the ECB rising?

The answer lies with inflation: when investors see inflation being likely in the future they ask for a greater compensation (yield) to be paid on their bond holdings. Hence, rising yields on German bonds is a signal of rising inflation expectations.

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"Overall, we still do not (yet) expect a considerable structural (i.e. permanent) rise in the inflation rate (i.e. to levels of clearly above 2%)," says Sebastian Becker, Senior Economist at Deutsche Bank.

But he adds, "we clearly see risk that price dynamics could strengthen more strongly through impaired supply conditions."

Becker says major upward risks in medium-term inflation stem from a greater-than-anticipated loss in potential GDP (reducing aggregate supply and hence leading to price pressures should demand overshoot.

He says prices could also rise on i) higher market concentration / pricing power of surviving firms in the aftermath of the pandemic, ii) a release of pent-up demand meeting temporarily reduced supply, iii) higher state-administered prices (driven by empty public purses), and iv) rising labour market shortages (due to population ageing) and employers’ incidental wage costs (due to the prospects of higher social contribution rates).

"Against the backdrop of the current considerable fiscal and monetary support packages, inflation dynamics could resurface quickly," he adds.

British Pound on the Back Foot

We have noted in this article that some analysts are increasingly cautious on Sterling following a strong rally over the course of 2021, that left it looking technically overbought in some pairs.

The overbought conditions are particularly evident in the daily chart, where the Relative Strength Index (RSI) has been screaming overbought for a number of days (RSI in lower panel):

As can be seen in the above, the RSI has moved above 70 which is unusual given the typical state of equilibrium would see it oscillate below here; a reading above 70 signifies GBP/EUR has entered overbought territory.

For the RSI to normalise a period of decline or consolidation in the exchange rate would be required.

The rallying Euro therefore provides an opportunity for Sterling to unwind from overbought.

However, strategists at the world's largest prime broker of foreign exchange, Citibank, retain a constructive stance on GBP/EUR.

"The Covid divergence narrative between the UK and Europe has been one reason behind recent GBP outperformance. While the narrative now looks increasingly priced in recent days after PM Johnson unveiled the national reopening plan, there could still be further room to run," says Kurran Tailor, an analyst at Citi.

CitiFX Strategy does not see the UK reopening trade as fully priced, nor longer term GBP positioning as particularly stretched.

On EUR/GBP, CitiFX Technicals notes a major support range at 0.8570-0.8596, which consists of a long term rising trend line converging with the Dec 2019 and Jan 2020 highs and a 76.4% retracement level.

(EUR/GBP 0.8570-0.8596 equates to GBP/EUR at 1.1633-1.1670.)

"If we see a daily close below this range, that would suggest a potential for an accelerated decline at least towards the March and May 2019 lows at 0.8473-0.8490, which is slightly above the head and shoulders target at 0.84+," says Tailor.

(EUR/GBP 0.8473-0.8490 = GBP/EUR 1.1780-1.18.)

CitiFX's bias is that GBP/EUR has further room for ascent above the 1.19 handle and the rise may extend ultimately towards the formidable resistance range at 1.2030-1.2082, which consists of the highs from December 2016, April 2017, December 2019 and January 2020.