Pound Sterling Uptrend Against Euro Stress Tested from Both Sides

• GBP/EUR tests major supports on charts
• Claims of Russian de-escalation lift EUR
• BoE policy uncertainty weighing on GBP

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The Pound to Euro exchange rate reached new 2022 lows after placing a major level of technical support under pressure in the mid-week session amid an ongoing rally by the single currency and a persisting underperformance by Sterling.

Pound Sterling slipped below 1.18 against the Euro for the first time since December on Wednesday after the single currency rallied in the prior session following suggestions of a Russian de-escalation in Ukraine, which has been followed by a troop withdrawal from the region around the country's capital Kyiv.

“Yes, we have a potential peace positive in the status of Crimea reportedly being kicked into the long grass for 15 years. Ukraine can remain neutral, outside NATO. It might even be allowed to join the EU. But it insists on inviolable security guarantees from the UK, Turkey, the US, France, and Germany that will force them to defend it - a de facto NATO Article 5,” says Michael Every, a global macro strategist at Rabobank. 

Some analysts have cautioned that the conflict is a long way from being resolved, while defence minister Sergey Shoigu did say in a Tuesday a conference call with leaders of the Russian armed forces that nascent troop movements merely reflect the fact that “the first stage” of the attack on Ukraine is complete.

Potentially misplaced optimism about developments on the ground in Ukraine has benefited a European single currency that was sold heavily in the wake of Russia’s February 24 invasion, although the Pound has also come under pressure due to a growing question mark over the outlook for Bank of England (BoE) interest rate policy.

Above: Pound to Euro rate shown at hourly intervals alongside EUR/USD. Click image for closer inspection.

"The recent re-pricing of the Bank of England tightening expectations seems to have left the pound in quite a vulnerable position in the crosses, and unable to truly benefit from the improvement in Ukraine-related sentiment," says Francesco Pesole, a strategist at ING. 

The Pound fell from the beginning this week after Bank of England Governor Andrew Bailey reiterated that the commodity-induced squeeze on incomes could potentially serve as a substitute for some of the additional increases in Bank Rate that financial markets have taken as given for later on this year.

“We are watching very carefully but facing very high levels of uncertainty as to what is the right combination of what I said earlier was the ‘natural and quite substantial hit to real income’ - this terms of trade shock that we’re facing - and the right use of monetary policy,” the governor told the economic policy think-tank Bruegel.

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“We recognise that the overall effect on inflation will be the sum of the two and I think the shock to real income is larger, and I think many commentators say this, than the single effect of monetary policy. But monetary policy is important. Not least because we have to guard against second round effects,” he also said on Monday.

Governor Bailey did acknowledge that some further increases in Bank Rate are likely to be necessary due to the current calibration of BoE monetary policy, which is still adding to inflation just as commodity prices and a strong labour market are threatening to bring about a protracted period in which inflation remains above two percent target.

But the governor also clearly and strongly implied that market expectations for Bank Rate to rise from 0.75% to 2% by year-end are likely on the excessive side of feasibility, triggering losses for the Pound to Euro exchange rate along the way.

Above: Pound to Euro rate shown at daily intervals with Fibonacci retracements of  April 2021 uptrend and 200-day moving-average indicating  areas of short-term technical support for Sterling. Click image for closer inspection.

“The recent consolidation looks to us like the “right-hand shoulder” to a classic inverted “head & shoulders” base, with key resistance seen at the February high and 200-day average,” says David Sneddon, head of technical analysis trading strategy at Credit Suisse, in reference to EUR/GBP. 

“The case for a “head and shoulders” base in EURGBP [“head and shoulders” top in GBP/EUR] is seen reinforced by the rate differential picture, with UK Bonds notably outperforming German Bonds over the past few weeks,” Sneddon said on Tuesday. 

The Pound’s losses have placed its 2021 uptrend under stress and drawn the attention of some would-be sellers who say that a “head and shoulders” topping pattern may now be in the process of forming on the charts.

While much about price action still likely depends on developments in Ukraine and demand for the single currency in the short-term, there is also risk of a market disappointment in relation to the BoE’s interest rate and this could eventually bite Sterling further over the coming months. 

"Based on the data we're looking at, and the performance of the EUR today against Asia (ex-Japan) and commodity-exporting currencies, it's possible that the focus of the FX market today has shifted from geopolitics to monetary policy expectations. EUR OIS rates for the June and July ECB policy announcement dates are gently moving higher," says Stephen Gallo, European head of FX strategy at BMO Capital Markets.

"Our preference is to slowly add a moderate amount of long exposure to spot EURGBP, as highlighted on Tuesday. We maintain that many of the EUR's core fundamentals remain on shaky ground. But the interest rate fundamental is shifting, and that is important for the FX market in the short-term, particularly with the June and July ECB dates not fully priced for a 25bps rate hike by our calculations (though they could be partially or fully priced for another reduction in asset purchases)," Gallo also said on Wednesday.

Above: Pound to Euro rate shown at daily intervals with spread, or gap, between yields on 02-year UK and German government bonds. Click image for closer inspection.