DNB Markets on EUR/GBP: The Impressive Call to Buy Sterling When Everyone Was Frantically Selling

"The recent sell-off in the British pound is exaggerated and a result of several potential risk factors materialising at the same time." - DNB Markets.

• This article was published at a time of heightened fears over the EU referendum in which the pound was under immense pressure. Subesequent action in sterling-euro following the release confirm DNB Markets to have been spot on with their recommendation.

A leading foreign exchange practitioner tells us that the number one question he is receiving from his clients this week is not whether the pound will fall further, rather whether it will bounce back. 

The question will primarily be asked by those who were hoping for a stronger GBP, but instead of levels above 1.40 against the euro they are now seeing 1.26 being commonly quoted.

Some good news for those under-fire readers as a bounce could be at hand according to research conducted by a leading European research house.

So convinced are DNB Markets, Norway’s largest investment bank, that the pound is now oversold against the euro they have recommended a trade to take advantage of a EUR/GBP fall.

“We expect to see a (bumpy) improvement of the global risk sentiment, the start of Cameron Bremain campaign reducing Brexit risk and interest rate expectations to rise. At the other side of the English channel, we expect Draghi to act on his guiding of further stimulus, keeping the EUR under pressure,” says Magne Ostnor, FX Strategist at DNB Markets.

The GBP has taken a serious beating lately and is now seeing levels 8-12 percent weaker over the last three months.

The euro to pound sterling exchange rate is seen trading 0.48% higher on a day-to-day basis having reached 0.7901.

There are four main reasons for the negative developments on sterling, all of which are interconnected; deteriorating global risk sentiment, weaker UK data, postponement of BoE rate hikes (and now even chatter of rate cuts) and Brexit fears.

The Pound is Heavily Oversold Against the Euro

The EUR/GBP rate should be lower if it were still following it's long-term driver - the difference between interest rate yields in the UK and Eurozone.

Ultimately, the two should meet up again at some point, which implies the pound should make a strong comeback against the euro.

Of course, the timing of this event is the hard part. But DNB believe there are a few trigger points to such a move lying ahead.

Market Recovery to Aid Sterling

The start to the year has been brutal in financial markets which have been sold on fears concerning the slowdown in China’s stellar growth which has long been taken for granted by global investors.

The euro has tended to benefit in this risk environment because gargantuan sums of cheap euros have been borrowed from Eurozone banks thanks to ECB rate cuts.

This currency has been invested in foreign markets, and with investors liquidating these investments so the demand for euros grows as loans are settled. So the euro benefits against the pound when markets sell, but importantly the euro is not necessarily a safe-haven.  

“While the list of things that worry us is long, and has the potential to distort markets again, we expect to have seen the worse for now. As GBP has been underperforming in this risk-off environment, we also expect it to benefit from a period of gradual improvement in sentiment,” says DNB's Ostnor.

EU Referendum Story is Getting Old

Chris Turner at ING says, ahead of the weekend, that should the UK manage to include into the G20 communique the reference of the Brexit being a risk to the global financial stability (as the news overnight suggest), there is a scope for a short-term GBP relief rally on Monday.

Turner cites the large degree of Brexit risk premium priced into GBP, and it seems to us that there simply is not enough new Brexit news to sustain the relentless selling we have seen of late. 

"Our model suggests that around 3-4% of risk premium is currently priced into GBP/USD, equivalent to the peak levels priced into GBP ahead of the Scottish referendum and UK parliamentary elections," says Turner.

Ostnor and his team are dismissive about the risks being associated with a UK exit from the EU.

While polls show a real risk for a yes to UK leaving the EU, “we expect the UK to remain a part of the EU as both parties will be better off avoiding Brexit,” says Ostnor, “recall the close polls ahead of the Scottish referendum and last year elections, while the final outcomes were substantially different from the polls.”

DNB note Cameron has this far been prevented from campaigning strongly for “Bremain”, as that would make the negotiations difficult.

However, “the next months should see the supporters of EU to mobilise heavily, reducing the current risk premium on the GBP,” says Ostnor.

Indeed, there are signs that already the public is shifting towards staying in the EU with the first set of polls since the settlement with EU leaders showing the case for staying has grown.

How does this translate into a trade on the EUR to GBP?

“Sell EURGBP @0.7880, with a target of 0.73 and a stop-loss at 0.81,” say DNB.

Risks to the Trade

As always, there are risks to the recommendation.

Brexit risks will continue to weigh on the GBP heading into the the referendum in June.

More will likely support the London mayor, Boris Johnson, in campaigning for a Brexit, keeping markets on high alert.

And should the general risk sentiment get another blow, this would be a GBP negative.

And, "given the recent stabilisaation of commodity prices, ECB could opt to wait and see for longer if core inflation will continue higher, thereby lifting inflation expectations," say DNB.