Strategists Back a Higher Pound Sterling Against the Euro

- GBP/EUR in recovery mode
- Gains aided by recovering markets
- EUR weighed by ECB
- Soc Gen back GBP/EUR above 1.20
- CBA are buyers of GBP against EUR

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The British Pound is predicted to appreciate in value against the Euro over coming weeks by a number of foreign exchange strategists we follow, with one suggesting levels of 1.25 cannot be discounted.

Strategists at the investment banking divisions of Société Générale, ING Bank and Commonwealth Bank of Australia have confirmed this week they expect further upside in the Pound against the Euro, noting a combination of supportive valuations and interest rate differentials.

The calls come at a time of increased volatility in currency markets that saw the Pound fall sharply against the Euro and Dollar at the start of the week before ultimately recovering those losses over subsequent sessions.

Pound Sterling has entered this recovery phase aided by signs the third Covid wave gripping the UK could be slowing while a rebound in stock markets appealed to the UK currency's 'high beta' personality.

Above: Despite a recent recovery, GBP is still nursing losses over a one-week timeframe.

A rebound against the Euro gathered pace on Thursday after the European Central Bank (ECB) said it would maintain generous levels of monetary support to the Eurozone financial system until inflation was deemed to be stabilising around the 2.0% level.

The stance suggests the ECB will remain one of the laggards in the global central bank race to normalise interest rates back to pre-crisis levels, a position that could weigh on the Euro over the longer-term.

The ECB's do-nothing stance contrasts to that of the Bank of England which appears increasingly nervous over inflationary levels in the UK, reflected by the fierce debate amongst policy makers as whether or not inflation will get stuck above 2.0% for a sustained period of time.

Money market pricing shows the Bank of England is expected by investors to raise interest rates in 2022, while the ECB is expected by markets to raise rates in 2024.

Some economists say lift-off at the ECB could be even later.

"The new forward guidance is consistent with our expectations that rates won’t be hiked in the euro area before late 2025," says Giovanni Zanni, Chief Euro Area Economist at NatWest Markets.

Zanni says it will take time before the year-ahead inflation forecast at the ECB matches the "2% durably" goal, "realistically not before late 2024 – early 2025, on our expectations," he adds.

The policy divergence between the two central banks is reflected in the Pound's steady uptrend against the Euro in 2021 which remains intact despite the wobble witnessed earlier this week.

Above: Daily chart showing GBP/EUR behaviour in 2021.

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According to Société Générale, the French international financial services provider and investment bank, the Pound-to-Euro exchange rate could move well above 1.20 by the autumn.

Soc Gen have updated their exchange rate forecasts and say the U.S. Dollar has bottomed and the British Pound is in the process of acclimatising to a new post-Brexit era.

"EUR/GBP seems to us to have moved to a post-Brexit era and is tracking rate differentials and shifting growth expectations rather more confidently now. The chart shows how that has been the case since the focus moved on from the referendum vote itself. EUR/GBP diverged from yields and spiked in 2019 as the EU departure date approached and the domestic political backdrop got very clouded," says Kit Juckes, Chief FX Strategist at Soc Gen in London.

"Since the initial COVID-related volatility calmed down, the two lines in the chart have moved in harmony. On that basis alone, the likelihood that the UK will tighten monetary policy well before the ECB suggests that EUR/GBP is now more likely to drift towards 0.80 than drift upwards towards 0.90," says Juckes.

0.90 in EUR/GBP is 1.11 in GBP/EUR and 0.80 gives a GBP/EUR exchange rate of 1.25, a target Juckes expects the exchange rate to gravitate towards this autumn.

Analysis from Amsterdam-based international banking giant ING Bank meanwhile shows the Pound has been left undervalued by a recent decline against the Euro, to the extent that EUR/GBP is now at its most overvalued since April.

"The latest GBP sell-off brought EUR/GBP to the most overvalued territory since April, with EUR/GBP currently screening 1.5% overvalued (which is just shy from the 1.5 standard deviation band) based on our short term financial fair value model," says Petr Krpata, Chief EMEA FX and IR Strategist at ING in London.

EUR/GBP rose to a high of 0.8669 on Monday, (GBP/EUR down to 1.1535) amidst a sharp sell-off in global markets that pulled the Pound lower. Investors sold the Pound and bought Euros as fears rose over the impact of the rapidly spreading Delta variant of Covid-19 posed to the global economic outlook.

However, a subsequent stabilisation in sentiment combined with an apparent overvaluation in the Euro relative to Sterling leads ING to expect a reversal of the Euro's gains.

ING's modelling suggests there is limited scope for EUR/GBP to move above the 0.8700 level (GBP/EUR below 1.1494).

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Despite valuations favouring the Pound, ING are nevertheless cautious that tensions are likely to rise once more between the EU and the UK over the issue of the Northern Ireland Brexit protocol.

Although Brexit happened in January the Protocol is still not fully functional given the significant technical challenges it poses.

Heightened cultural sensitivities are also preventing its full implementation with the Unionist community opposing a perceived separation of Northern Ireland from the rest of the UK.

The UK government on Wednesday announced it was seeking a substantial renegotiation of certain points contained in the Northern Ireland protocol as a result, adding that in its existing form it is prevent the trade in goods and medicines between Great Britain and Northern Ireland.

Brexit minister David Frost told the House of Lords that the Government is now proposing a number of major changes to the Protocol, which the EU flat-out rejected.

In fact, the EU said on Thursday they intend to escalate legal action over the matter.

If the two sides cannot agree a sustainable solution to the matter before the current grace period expires on October 01 tensions could soon start to be reflected in Sterling exchange rates.

A clash is coming, "this suggests that sterling's recovery back to short-term fair value is not imminent," says Krpata.

European Commission President Ursula von der Leyen said Thursday the EU will nevertheless remain open to finding solutions to the issue.

"Boris Johnson called to present the UK Command paper on the Irish/Northern Irish Protocol. The EU will continue to be creative and flexible within the Protocol framework. But we will not renegotiate. We must jointly ensure stability and predictability in Northern Ireland," she said in a brief statement.

History suggests tensions between the EU and UK tend to ramp up ahead of an inevitable breakthrough and markets will therefore opt to look through the noise for now.

Indeed, strategists at Commonwealth Bank of Australia are sticking with a view the Pound is a solid bet against the Euro.

In a regular currency briefing out on July 22 they maintain buying the Pound and selling the Euro is the only conviction call remaining on their books.

Like ING, CBA see valuation as favouring gains by the Pound.

"Valuation and relative economic performance between the UK and the Eurozone are the reasons we continue to expect a lower EUR/GBP. The UK CBI business optimism dipped in July but remains consistent with solid economic activity over the next three months," says strategist Elias Haddad at CBA.