Euro in Strong Start to July against the Pound, but Faces an Increasingly Challenging Outlook

• Eurozone CPI burns hot, supports EUR
• Market already bearish on UK and GBP
• But EUR could be about to suffer a sentiment downgrade
• As Barclays forecasts a winter recession
• Berenberg agrees, citing stalling M1 money supply

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The Euro strengthened in the first trading session of July with investors digesting inflation data that showed prices across the Eurozone continue to rise which pushed up bets for European Central Bank action, but the single currency faces a challenging outlook as some economists warn of impending recession.

The Euro outperformed the Pound on the day Eurostat revealed Eurozone CPI inflation read at 8.6% year-on-year in June, up from 8.1% in May and beating expectations for a reading of 8.4%.

Italy reported a sizeable 1.2% leap in prices in the month to June, outstripping expectations for 0.6% growth, taking the year-on-year change to 8.0%.

This comes after after Spain announced its CPI growth reached a record 10% year-on-year in June.

The data heaps pressure on the European Central Bank to raise interest rates and a sizeable 50 basis point hike in July cannot now be ruled out. The Pound to Euro exchange rate slumped by half a percent day-on-day to read at 1.1550.

The currency and money market reactions and price responses would suggest on balance this is supportive of the Euro.

"A few weeks ago, I argued that the ECB couldn't exit negative rates in one hit because of the impact it would have on financial stability. But with rates and bond markets now adequately primed, seems like there is no excuse to pull the trigger on 50bp," says Simon Harvey, Head of Research for Monex Europe.

Inflation might be supportive of the Euro now, but it could soon turn into an outright headwind as it grinds growth lower and plunges the Eurozone economy into a period of stagflation.

Economists at Barclays have this week revised their Eurozone economic forecasts and now say they expect a Eurozone recession by the winter.

"We forecast below-consensus euro area growth over the summer and a recession in the winter, predicated in part on shrinking real incomes," says Mark Cus Babic, Macro Research Analyst at Barclays.

A recalibration lower of Eurozone growth expectations relative to the UK could ultimately prop up the Pound to Euro exchange rate as foreign exchange markets continue to observe the differing fortunes of the major economies.

Economists at NatWest Markets earlier this month said the Pound's ongoing decline against both the Dollar and Euro reflects the pessimism amongst economists regarding the UK's economic growth prospects for 2023.

This is encapsulated in the below chart detailing changes in economist expectations for 2023 growth:

Above: GDP consensus expectations for 2023. Source: Bloomberg, Natwest.

NatWest currency strategist Paul Robson said last week he believes peak pessimism on the UK economy and the Pound has now potentially been reached, leaving the Euro more exposed to downside if Eurozone growth forecasts are downgraded.

Barclays says Eurozone households saved a bigger portion of their income over the pandemic but the savings rate is now close to its pre-crisis level, leaving little cushion for consumers as they are hit by soaring prices.

They find in the case of Germany the excess savings that consumers can fall back onto in the face of rising inflation is now effectively zero.

"This is not because German households decided to spend the excess cash, since they were still accumulating financial assets (cash plus others) at roughly the same rate as the EA as a whole. Instead, faced with swollen bank balances, Germans accumulated cash at a rate lower than pre-pandemic and diverted this money into the stock market, bringing the cash balance closer to its pre-pandemic trend," says Babic.

Barclays have downgraded their Eurozone real GDP growth forecasts for 2023 substantially and expect a technical recession to be in place by the turn of the year in all countries.

Economists at Berenberg Bank meanwhile say M1 money supply in the Eurozone is now flashing red.

"Over the past 30 years, no chart or model has served us better to predict Eurozone growth than a look at money. Real M1 money supply often heralds major turning points in the business cycle some two to three quarters in advance. Unfortunately, the message of the chart is clear: judging by the real value of the highly liquid balances of households and non-financial companies, the Eurozone is heading for a downturn," says Holger Schmieding, Chief Economist at Berenberg.

A recession around the turn of the year would imply the European Central Bank has a very limited window in which to raise interest rates in an effort to bring inflation down.

Falling ECB rate hike expectations would in turn mechanically weigh on the Euro and offer support to the GBP/EUR exchange rate, all else being equal.

Highlighting the importance of relative growth expectations for exchange rates was last week's decline by the Euro following the release of PMI data that showed the Eurozone economy slowed sharply in June on stalling demand growth.

The Eurozone's Composite PMI read at 51.9, meaning the Eurozone economy was close to falling below the key level of 50 which marks the line between growth and contraction.

"The subcomponents of the survey suggest a dip below that level in the coming months," says economist Giovanni Zanni at NatWest Markets.

Above: "Real time indicators point to slowdown in Q2" says NatWest, citing the ability of truck milage data to indicate the health of the economy.

The UK's equivalent PMI data meanwhile came in ahead of expectations which supported the Pound against the Euro.

If the market continues to downgrade Eurozone growth expectations over coming days and weeks Euro weakness could evolve, particularly against the Pound as UK economic sentiment might have already reached peak negativity.

"To be sure, the economic outlook in the UK looks increasingly challenging, as price rises, in particular for fuel and energy bills, are hitting consumers' wallets. But the economy is expanding, labour markets are tight, and prices are climbing, so we still expect the Bank of England (BoE) to hike four more times before the year is out," says Thomas Flury, Strategist, at UBS.

UBS forecasts Euro-Pound to trade around 0.85 through the remainder of the year, which is 1.1765 in Pound-Euro terms. (Set your FX rate alert here).