GBP/EUR Rate Powers to 21-month Best

The Pound to Euro exchange rate rallied to a new 21-month best at 1.1784 after German state-level inflation pointed to a slowdown in May, but analysts warn levels above 1.1765 won't be sustained.

Euro exchange rates were under pressure after German state-level inflation showed a sharp slowdown that raises the prospect of a soft Eurozone inflation print on Friday that opens the door to consecutive rate cuts at the European Central Bank in June and July.

The most populous German state, North Rhine Westphalia, saw inflation slow to 0.2% month-on-month in May from 0.3% in April. In Saxony, inflation slowed from 0.6% to 0.1%; in Hesse, inflation flatlined at 0% from 0.6%. Bavaria saw inflation drop from 0.6% to 0.1%.

The all-Germany inflation print came in at 0.1%, down from 0.5% and below the 0.2% expected. German data can sometimes overshadow the Eurozone inflation figure that is due two days later, meaning this week's Euro's inflation-related move is already underway.

By late morning, the Euro was lower against all its G10 counterparts, meaning this is a Euro-specific move driving GBP/EUR to fresh highs. 

The European Central Bank will cut interest rates in June, but a soft Eurozone inflation print on Friday could raise the odds of a second cut in July. This would put the ECB at the forefront of the rate cutting cycle and penalise the Euro against currencies belonging to central banks that will be more reticent to cut rates.

The midweek rally takes Pound Sterling to above the upper reaches of the 2024 range against the Euro, and for some analysts the exchange rate is starting to look expensive.

ING's Global Head of Markets for UK & CEE, Chris Turner, says he is backing resistance located near €1.1765 to hold as the Pound looks set to ignore domestic politics and instead reflect Bank of England interest rate expectations.

"We think the market pricing of just 33bp for Bank of England rate cuts this year is far too modest. And we think EUR/GBP will largely hold support near 0.8500," says Turner. EUR/GBP at 0.85 equates to a GBP/EUR conversion at 1.1765, which is the location of the upper-end resistance band:

Above: GBP/EUR at daily intervals showing potential resistance. Track GBP/EUR with your own custom rate alerts. Set Up Here

As can be seen in the above, although GBP/EUR has risen over recent days, it is still yet to convincingly defy the gravity of the 2024 range.

The rally comes as investors gauge the potential impact of a Labour government taking the reins on July 04. Thus far, markets appear relatively sanguine about such a prospect; some analysts say a strong Labour majority could, in fact, be supportive of GBP.

"EUR/GBP continues to trade on the lows. Labour's Shadow Chancellor, Rachel Reeves, is making all the right fiscal noises - although the Labour Party may find they've boxed themselves from a policy perspective should they win July's general election. For reference, the UK's sovereign five-year credit default swap (CDS) is falling and at 25bp. The equivalent US CDS is rising and at 43bp," says Turner.

File image of Labour leader Keir Starmer and Shadow Chancellor of the Exchequer Rachel Reeves. Image © Keir Starmer

"While the decline in the UK CDS is welcome - and a far cry from the spike over 50bp witnessed during the brief Liz Truss government in 2022 - we think sterling will still largely trade off the interest rate story," he adds.

The odds of a June rate cut at the Bank of England shrank in the wake of last week's above-consensus UK inflation print. They all but evaporated after Prime Minister Sunak announced the country would go to the polls on July 04 as all civil servants - including those on the Bank of England's MPC - enter a period of purdah.

This enforced radio silence means the Bank cannot steer market expectations towards a June rate cut, which means such a move would represent a big surprise to a market that is not expecting it.

Most economists we follow think an August cut is likely. "We think the market pricing of just 33bp for Bank of England rate cuts this year is far too modest," says Turner.

33bp suggests the market is prepared for just one cut. Pricing in a second, or even a third cut (assuming an August kick-off), suggests scope for market expectations to recalibrate and potentially weigh on the Pound.