Pound / Euro Rate Outlook Dimmed by Sign of Inflation Paradigm Change

Modified: Thursday, 24 March 2022 14:09 GMT
Written by: James Skinner

GBP/EUR passes possible inflection point
Inflation may become GBP headwind
On uncertainty over BoE’s likely response
If energy inflation taken as self-defeating
Could limit GBP/EUR recovery short-term
May see markets left hanging further out

Image © Adobe Stock

The Pound to Euro exchange rate climbed back above the 1.20 handle this week but could find it more difficult to rise further during the months ahead following an early sign that rising levels of inflation may be on the cusp of turning from a supportive tailwind to an inhibitive headwind for Sterling.

Sterling was higher against the Euro and currencies of other large energy importing countries on Thursday amid fresh concerns in markets about the supply of Russian gas in Europe after the Kremlin said it will soon require payment for these products in Roubles rather than Euros or Dollars.

The latter would undermine western sanctions on Moscow over its invasion of Ukraine and so has stoked renewed concerns about an accelerated attempt by European countries to reduce their dependence on Russian resources, which prompted energy prices to increase and the Euro to weaken.

Runaway oil and gas prices have so far had an uplifting influence on the Pound to Euro exchange rate, although there are other factors that could limit its scope for gains in the short-term and potentially even lead to weakness in Sterling during the months ahead.

“In view of the looming downside risks to the economy, we think there is a rising possibility that the FX market will not treat future upside inflation surprises as GBP-positive,” says Stephen Gallo, European head of FX strategy at BMO Capital Markets.

Above: Pound to Euro exchange rate shown at hourly intervals alongside GBP/USD.

Reference rates at publication:
GBP to EUR: 1.2020
High street bank rates (indicative): 1.1598 - 1.1682
Payment specialist rates (indicative): 1.1911 - 1.1940
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While the Pound-to-Euro rate was aided by concerns about energy supply on Thursday, it had gotten no help on Wednesday when official data showed inflation climbing above six percent in February only for Sterling to then ease lower against the Euro and Dollar throughout the day.

This is potentially the first sign of inflation being on the cusp of turning from a tailwind to a headwind for Sterling since the BoE called market assumptions about the outlook for interest rates into question this month.

“Further out, inflation was expected to fall back materially, and possibly to a greater extent than had been expected in the February Report, as energy prices stopped rising and as the squeeze on real incomes and demand put significant downward pressure on domestically generated inflation,” the BoE said, among other things, in paragraph 56 of the minutes from its March policy meeting.

The BoE suggested strongly in its March update that the squeeze on incomes induced by commodity price increases will eventually have a self-defeating impact on inflation that could act almost as a partial substitute for some of the interest rate rises expected by the market for later this year.

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“Headline inflation in the UK has surprised to the upside for the last four consecutive reports which has been followed initially by [GBP/USD] strengthening marginally on three out of four occasions,” says Lee Hardman, a currency analyst at MUFG.

“There is now a higher hurdle for the GBP to strengthen more notably in the week ahead if there is another material upside inflation surprise in light of the BoE’s increased focus on downside risks to growth from higher inflation,” Hardman and colleagues wrote in a research briefing last Friday.

Previously rising inflation figures had a favourable influence on the Pound and part of the reason why may have been the market’s general assumption that the Bank of England would be likely to respond to it by lifting interest rates further during the year or so ahead.

But with that assumption now in doubt just as soaring energy prices threaten to lift inflation substantially over the remainder of the year, there is a question mark over whether such developments will remain supportive of Sterling and one that could grow further in size during the months ahead.

Above: Pound to Euro exchange rate shown at daily intervals alongside GBP/USD.

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"We see the potential for further BoE rate rises to be already running out of road. Assuming the market retains its expectation that the ECB could start to tighten policy at the end of 2022, EUR/GBP is likely to trend higher into the middle of the year and beyond. This view, however, is caveated by the stagflationary risks which could come from a worsening in the energy crisis in Europe,” says Jane Foley, head of FX strategy at Rabobank.

The BoE’s language in March about energy prices posing downside risks to its inflation target over the longer-term implies a risk that it could decide at a coming meeting to avoid lifting Bank Rate again, which would potentially lead to an upset for Sterling and declines in the Pound to Euro exchange rate.

This is all the more likely since Governor Andrew Bailey reiterated on February 23 statements made in last month’s Monetary Policy Report press conference including the revelation that some at the BoE thought it would make sense to take a break from raising interest rates in the near future.

The BoE lifted Bank Rate on a third consecutive occasion earlier this month, returning the benchmark to the 0.75% it was at prior to the coronavirus-induced cuts that were announced in March 2020.

Its latest forecasts did also suggest that Bank Rate would be likely to rise further during the months ahead, although when and to what extent borrowing costs increase again will likely be a key influence on the Pound to Euro exchange rate over the remainder of the year.