GBP/EUR Week Ahead Forecast: Euro Key to Recovery

• GBP/EUR struggling with resistance near 1.1518 on charts
• Scope to find support around 1.1494, 1.1424 on weakness 
• European inflation, ECB policy implications key short-term 
• Risk of upside surprise, volatility in European bond market

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The Pound to Euro exchange rate's year-to-date rally has been frustrated by a major level of technical resistance on the charts thus far in the latter half of May but the consolidation around the 1.15 level could give way in either direction following this Thursday's release of European inflation figures for April. 

Sterling was little changed against the Euro for the week to Monday after another attempt at climbing above Fibonacci resistance at 1.1518 on the charts ended in failure shortly after UK inflation fell by less than was expected for the month of April last Wednesday. 

The Pound rallied briefly above the 50% Fibonacci retracement of its downtrend from last February only to be overcome by heavy selling originating from the bond market where government yields surged alongside market-implied expectations for the Bank of England (BoE) Bank Rate up ahead.

"The upside surprise in UK CPI was large enough to add fuel to a Gilt and global fixed income selloff that dented risk sentiment, and in turn weighed on Sterling," says Michael Cahill, a G10 FX strategist at Goldman Sachs and a recent advocate buying GBP/EUR.

Above: Pound to Euro rate shown at daily intervals with selected moving averages and Fibonacci retracements of April rally indicating possible areas of technical support for Sterling. 

Derivative markets have shifted rapidly to imply a high probability of the BoE Bank Rate being raised to 5.5% since last week's data suggested April's decline in inflation was the result of earlier declines in energy prices. 

That was further evidenced by the core inflation rate, which climbed from 6.2% to 6.8% after prices of domestically produced goods and services rose in various categories following the turn of the financial year, which is exactly the kind of price increase the BoE has been attempting to prevent. 

"Given high uncertainty on the outlook and the speed with which monetary tightening is being transmitted to the economy, we think the MPC will likely proceed with 25bp steps, rather than reverting to 50bp hikes," says Abbas Khan, an economist at Barclays.

Newly-increased expectations for Bank Rate are an immediate headwind for the UK economy given that rates charged to mortgage borrowers are based on the market-implied rate and not the actual Bank Rate, meaning households can now expect to be charged 5.5% or more when renewing fixed-rate mortgages. 

Above: Change in market-implied expectation for BoE Bank Rate between selected dates. Source: Goldman Sachs Marquee. 

Rate expectations have crept higher throughout much of the year after official figures and private sector barometers suggested the economy has been more resilient than many expected, leading the BoE to upgrade its forecasts this month with new projections now indicating modest growth for 2023.

"While we will be closely watching to see if Sterling sentiment deteriorates more materially, we think there is still a strong argument for more forceful action to slow inflation and strengthen the currency," Cahill and colleagues write in a Friday research briefing. 

The Goldman Sachs team suggested earlier in May that clients buy Sterling and look for a move up to 1.1627 in the weeks or months ahead but whether it gets any closer to that level this week is likely to depend most on the market response to European inflation figures due out on Thursday.

Europe's inflation figures are the highlight for the Pound to Euro rate in what is a quiet week for UK economic data but there is uncertainty over the likely outcome as well as in relation to how the market would be likely to respond if price pressures remain equally stubborn on the continent. 

Above: Quantitative model estimates of ranges for selected pairs this week. Source Pound Sterling Live. Click the image for a more detailed inspection.

"Eurozone CPI can potentially cause some volatility on Thursday. The consensus of economists expects a fall in both headline and core inflation," writes Joseph Capurso, head of international economics at Commonwealth Bank of Australia, in a Monday research briefing. 

"However, we think the risk lies towards a stronger CPI given the strength in the UK’s core CP. The stronger-than-expected UK CPI caused the GBP/USD to fall as it raised concerns that much more interest rate tightening could push the UK into a recession.

Surveyed economists are looking, on average, to see Europe's inflation rate fall from 7% to 6.3% for April and for the core inflation rate to have edged lower from 5.6% to 5.5% but the risk is potentially on the upside for both prices and the Pound to Euro rate. 

Sterling might benefit if the market responds to any stronger-than-expected inflation in the same way as it did with the UK data last week, although the Euro could also fall temporarily if large declines are perceived as making further increases in European Central Bank (ECB) interest rates less likely. 

Above: Pound to Euro rate shown at weekly intervals with Fibonacci retracements of February 2022 downtrend indicating possible areas of technical resistance. Selected moving averages denote support and resistance.