GBP/EUR Tests Key Support after Eurozone Inflation Surprise

• GBP/EUR extends trend of weakness
• EUR remains bid in wake of EZ inflation
• Eurozone core inflation rises unexpectedly
• Pressuring ECB to extend rate hikes

The Pound to Euro exchange rate (GBP/EUR) extended a trend of weakness following the release of Eurozone inflation data that showed the pace of price increases in the single currency area remained stubbornly high in December.

The data underpins the European Central Bank's warning that two more 50 basis point hikes were to come in the new year.

The Euro has been bid against the Pound, Dollar and other currencies since December's warning from the ECB that it would need to take further forceful action on interest rates in order to get a handle on inflation.

The message was more strident than investors were expecting and contributed to a rally in Eurozone bond yields and the Euro.

Eurozone CPI inflation for the year to December read at 9.2%, which was in fact notably lower than the consensus expectation for a reading of 9.7% and was lower than November's 10.1% reading.

But, it is the core CPI reading that is arguably more important to the ECB and Euro exchange rates, given this is the element of inflation that reflects on developments in the domestic economy and is therefore malleable to monetary policy.

Core CPI rose to 5.2% year-on-year in December, defying expectations for a print of 5.0% and an acceleration on November's 5.0%.

"Resilient core inflation will likely mean the ECB hawks can stand their ground for now," says Dominic Bunning, Head of European FX Research, HSBC Bank plc.

The ECB's own forecasts show energy and food prices will come down, but core inflation might prove more resistant and ensure inflation remains anchored above the 2.0% target over the medium term.

Therefore the data would underpin the December message from the ECB that more work needs to be done, in turn supporting Eurozone yields and the Euro.

The Pound to Euro exchange rate extends a trend of weakness and is now at 1.1285, putting it on the cusp of a key line of support located in the vicinity of 1.1270:

Above: GBP/EUR at daily intervals showing key support levels. Consider setting a free FX rate alert here to better time your payment requirements.

Should the pair break through this support level further momentum to the bottom of the 2022 range could transpire.

The Euro retains support from falling domestic energy prices amidst high deliveries of LNG that is filling the gap left by Russia's departure from the market.

Furthermore, unseasonably warm weather and associated high wind levels are aiding the decline in prices that will boost the region's economy and lower headline inflation prices.

Rising ECB interest rates are meanwhile boosting the attractiveness of European monetary assets, boosting capital inflows.

"ECB President Lagarde has warned about delayed pass-through of gas and electricity price increases in the January inflation print, but barring new energy price spikes, momentum has probably turned and inflation will come down gradually during 2023," says Anders Svendsen, Chief Analyst at Nordea Markets.

If you are looking to protect or boost your international payment budget you could consider securing today's rate for use in the future, or set an order for your ideal rate when it is achieved, more information can be found here.

Svendsen says the focus is now likely to shift from the level and timing of the inflation peak to the pace of the inflation drop in the first half of the year and the underlying persistence in core inflation.

"As a starting point the ECB has indicated two times 50bp hikes in February and March. New staff projections for inflation - available at the March meeting - will likely determine the signals about additional rate hikes thereafter," he adds.

The first major economic release of 2023 is therefore consistent with a firm Euro: the good news that headline inflation is falling suggests upside risks to the economic outlook.

However, with core inflation remaining sticky the ECB will deliver further interest rate hikes to bolster the yield on Eurozone financial assets, conferring further support to the currency.