Pound to Euro Exchange Rate Bolstered by Improved Market Sentiment, Upside Limited

Image © Bank of England

Pound Sterling has recovered against the Euro alongside improved market sentiment and we see two credible upside targets for the exchange rate.

The Pound to Euro exchange rate (GBP/EUR) is seen at 1.1860 on Friday as it holds a moderate weekly gain, and we think it can extend higher to a first interim ceiling located at 1.1882 in the next one to two days.

However, gains will only be delivered if global equity market sentiment remains constructive through Friday and into the new week. Our coverage has shown that market sentiment has been the key driver of GBP performance this week, with Wednesday's selloff being linked to a fall in U.S. markets.

The correlation between GBP/EUR and the U.S. S&P 500 index is particularly strong and means the Pound has been able to recover midweek losses against the Euro thanks to gains in the stock market.

"The Nasdaq Composite climbed another 1% higher towards 17580. S&P500 gained towards, but not above, 5600. The move lower in U.S. yields drove the relative tech-stock outperformance," says a note from Citibank's FX dealing division.

The resilience in global markets helped Pound Sterling keep Euro strength at bay after a European Central Bank (ECB) decision to cut interest rates. The move did not weigh on the Euro as the decision was well anticipated.

Instead, we thought the guidance and new forecasts were supportive of the Euro as they did not encourage markets to bet that the ECB would step up the pace of rate cuts. Had that been the case, euro exchange rates would have come under pressure.

On the flip side, had ECB President Christine Lagarde pushed back aggressively against current expectations for more than one 25 basis point rate cut over the remainder of 2024, the Euro would have rallied.

But the guidance was steady, with statements that might lean in one direction being counterbalanced by additional statements and forecasts that might offset any market effect.

Economists think the ECB will continue to cut interest rates once a quarter, which offers a steady path ahead for the Euro and can keep it well supported.

This can ensure the Euro trades in a robust fashion and will limit any Pound-Euro upside potential to the 1.1882-1.19 area.

Clouds on the Horizon for Sterling Bulls

Above: Goldman Sachs thinks the market is vastly underestimating the pace of BoE rate cuts to come. Image courtesy of Goldman Sachs.

Although the near-term price action is supportive of the Pound courtesy of the global setup, central bank policy will soon come back into view, with next week's inflation report being the key risk to the Pound.

We see asymmetric risks to the Pound, which will prove highly sensitive to an undershoot in the data and less sensitive to any upside surprises.

Markets are already expecting the Bank of England to keep rates unchanged next Thursday, but should inflation undershoot, it could raise expectations for further cuts down the line. This would weigh on the Pound.

Goldman Sachs thinks the Bank will step up the pace of rate cuts from November, as inflation is set to cool and wage prices set to fall.

Economists at the Wall Street bank see a steeper path of rate cuts from the Bank than the market is currently pricing, and this poses significant downside risks to the Pound if it is proven correct.

"We now expect the Bank of England to move to consecutive cuts starting at the November MPC meeting; we have left the terminal rate unchanged at 3%, below market pricing," says Sven Jari Stehn, an economist at Goldman Sachs in London.

Stehn says this new baseline expectation has a 40% probability attached.