Can ECB Throw Pound-Euro A Lifeline?

• 'Hawkish hold' could boost Euro exchange rates
• But a neutral stance is the most likely outcome (65%)
• This won't dent the Euro's recent resilience
• Euro weakness likely if ECB noticeably more cautious on economy

Image © European Central Bank

The Pound to Euro exchange rate has fallen to five-month lows and today's European Central Bank (ECB) decision is unlikely to improve the outlook for an under-pressure Pound Sterling; in fact, risks are tilted to further losses.

This is because the central bank will likely prove keen to send an unambiguous message that it could raise rates again in December despite choosing to keep interest rates unchanged today.

A decision to hold interest rates is almost fully 'priced in' by the market, meaning euro exchange rates have already accounted for the decision.

Instead, it is the guidance that matters, and where the Euro trends over the coming days will depend on how credibly the ECB expresses a desire to keep interest rates at elevated levels for an extended period.

"In the current inflationary environment, where bringing inflation back to target has been a real concern for policymakers, we may see the ECB opting for a higher risk of recession over their credibility about controlling inflation being undermined. This could mean further rate hikes, albeit unlikely at the meeting this week," says Daniela Hathorn, Senior Market Analyst at Capital.com.

The ECB is, therefore, likely to signal a rate hike in December cannot be discounted.

Such a 'hawkish hold' at the ECB should do little to dent the Euro's ongoing rally against the Pound and its recent resilience against the Dollar.

The Euro to Pound Sterling exchange rate has risen 2.65% from its July lows at 0.8490 to reach 0.8720 at the time of writing (this translates to a five-month low at 1.1470 for the Pound to Euro conversion).

The Euro is meanwhile back at 1.0580 against the Dollar, which suggests the pair has moved back above a daily descending trendline, putting it on a firmer footing.

"The Euro has been showing some resilience in recent weeks, rising to a 5-month high against the British Pound (EUR/GBP) and breaking above its descending channel for the first time since it started back in July against the US Dollar," says Hathorn.

Rising oil prices, and the growing risks they remain elevated owing to Middle East tensions, suggest the ECB might have to contend with stickier inflation rates going forward.

Foreign exchange strategists at TD Securities see a potential upside of 0.45% for the Euro in the event of a 'hawkish hold', whereby the ECB emphasises that geopolitical instability could warrant further hikes if the subsequent inflation shock is large enough to feed through persistently into inflation expectations.

But TD Securities sees this 'hawkish' outcome as being a relatively low risk, instead assigning a 65% probability to the ECB striking a neutral tone.

Here policy policymakers keep language roughly unchanged relative to September and "essentially implies that they are highly unlikely," says TD Securities.

Under such circumstances, mild Euro weakness can be expected.

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The Euro could weaken more considerably if Lagarde strikes a noticeably cautious tone, which would not be entirely unexpected given the recent growth slowdown in European economic growth and rising tensions in the Middle East.

Eurozone PMI figures released this week signalled the Eurozone's economic downturn accelerated at the start of the year's final quarter, with the composite PMI reading at 47.8, down from 48.7 in September and below expectations for 48.7.

"We expect the ECB to deliver a 'dovish hold' on Thursday, whereby it keeps rates unchanged and warns that mounting risks to the outlook warrants a greater degree of caution," says Matthew Ryan, Head of Market Strategy at Ebury.

S&P Global - compilers of the PMI survey - said businesses in the Eurozone reported that new orders fell at an accelerating rate, pointing to a worsening demand environment for goods and services.

Furthermore, bond yields have risen across the Eurozone, which has helped to tighten monetary conditions, strengthening the ECB's case to hold rates unchanged.

"Should Lagarde voice heightened concerns over the possibility of a recession, while flagging geopolitical tensions and the sharp increase in government bond yields as risks to the economy, then the euro would likely sell off," says Ryan.

Money markets are pricing in the first rate cut in the second quarter of 2024, "a view that we think would be solidified should the Governing Council strike a downbeat tone this week," adds Ryan.