Bet on a Euro Recovery by Selling the Pound says Leading Strategist

It could be time to take a bet on a Euro recovery - and the best way of conducting this bet is to sell the Pound argues a leading foreign exchange analyst.

The Euro is widely being tipped to be the the next big winner on global foreign exchange markets according to a number of market commentators we follow.

It's not hard to see why the case for a bet on a stronger Euro is growing with the recent run of positive Eurozone economic data, especially forward-looking survey data, greatly reducing the need for further stimulus at the European Central Bank.

Indeed, the way data has been going of late actually opens up the possibility of interest rate rises at the Bank over coming months.

This pro-Euro assumption was most recently boosted by recent comments made by Austrian central banker and ECB member Ewald Nowotny who suggested some form of interest rate rise will be necessary at the ECB over coming months.

Also aiding the Euro's case are diminished fears of anti-EU nationalists taking power in key Eurozone states, particularly since the PVV party in Holland failed to gain power at elections last Wednesday.

Attention has now been turned to the more important French Presidential election on April 23, at which Marine Le Pen is threatening to take power, but her lacklustre representation in recent polls, combined with an increase in support for her main rival Emmanuelle Macron mean most analysts see her chances of winning as slim.

Macron's position has apparently been cemented following his assured performance in the first televised debate of the campaign in which he pushed Le Pen into third place.

The Euro's ascent could therefore be about to step up a gear should Macron sail through to the Presidency.

How to Bet on the Euro's Recovery

With all these factors calling for an upgrade of the Euro, the question now on many trader’s minds will be how best to trade it, for maximum benefit?

Whilst EUR/USD has got a lot of attention lately, the downside for the USD following the Fed meeting last week is still seen by many as something temporary rather than ‘structural’ and they remain bullish longer-term.

The focus, therefore, has now turned to EUR/GBP, which may be a better way to take advantage of the Euro’s newfound strength because of fears of political risk causing vulnerability to the Sterling.

“EUR/GBP is one of our preferred ways of trading Euro longs, though it has run into selling at 0.88 twice now in 2017. UK data this week will see CPI on Tuesday with inflation probably rising to 2.1% and retail sales on Thursday, expected to show am 0.8% m/m fall ex auto fuel,” says Société Générale’s Kit Juckes in a note seen by Pound Sterling Live.

Commenting on the up-and-coming UK Retail Sales data release he says:

“If we start seeing evidence of a squeeze on real incomes bearing down on retail sales volumes, that would be a clear negative for Sterling.”

Indeed, there is a risk Retail Sales is beginning to enter a more protracted decline as the impact of inflation starts to lead shoppers to look for deals and tighten their belts. Lacklustre wage rises also mean household incomes are losing ground to high-street price inflation.

Lacklustre wage rises also mean household incomes are losing ground to high-street price inflation.

If we are not careful the Pound could enter a reflex downwards spiral, as inflation causes restraint, which leads to subdued growth and an even weaker pound.

Bank of England Optimism Not Warranted

Those who see potential in the Euro versus Pound trade dismiss the positive tone of the last Bank of England meeting, which actually led to a strong rebound in the Pound.

Markets were not expecting the dissent of Kirsten Forbes despite her hawkish reputation, after the Chancellor reigned back investment and spending in his Spring budget.

It was thought this would lead to the BOE having to shoulder more of the burden of stimulating the economy in the event of a Brexit-related slowdown, and therefore encourage the BOE to adopt a more cautious accommodative stance.  

Forbes resolute stance in favour or raising interest rates, however, as well as the commentary from the meeting minutes which suggested wider support for a rate hike (data permitting) wrongfooted the market and led to a lead in the Pound.

Analysts are however wary of reading too much into the Bank’s tone.

Daniel Vernazza, Lead UK Economist at UniCredit Research in London warned that this hawkish tone “won’t last.”

“In our view, however, there exists a comfortable majority on the MPC that has little or no desire to tighten policy anytime soon and, moreover, the likely slowdown in UK economic growth amid a squeeze on real incomes and Brexit-related uncertainty should quash any further dissent.”

Sharing this scepticism is Philip Shaw at Investec:

“Overall Sterling rose in response to the minutes while the yield curve steepened. Even so, interest rate markets are not fully pricing in a 25bp hike in the Bank rate until the back end of 2018. In the absence of unexpected resilience in the economy or a notable pick up in wage growth, we suspect that the first move might well even occur beyond then.”

Shaw is wary that there are no signs of a steepening rise in earnings in the UK - something that would be required to prompt the Bank into action.

In fact, and as the minutes pointed out, January’s earnings data were relatively soft.

Pound too Undervalued to Bet Against

Not all analysts are in agreement about the Euro rising versus the Pound.

One of the main naysayers to the long Euro/short Pound hypothesis is chief strategist Hans Redeker at Morgan Stanley.

We reported back in February that Morgan Stanley think that it will be loose global liquidity conditions, increased political uncertainty in the Eurozone, combined with an undervalued GBP which will drive the EUR/GBP pair lower.

While they are no longer advocating this trade owing to the Euro's recent strong performance they say they like "staying Long GBP" citing the Pound as being undervalued.

“Bearish GBP positioning is heading towards the extreme again even as real yield differential warns that the current GBP level does not make too much sense when applying optimal portfolio rules,” said Morgan Stanley’s Redeker.

Political risks associated with Brexit negotiations and Scoxit are exaggerated and that the chance of the UK remaining whole and agreeing a positive trade deal with the EU has not been adequately represented in market pricing.

Investors are, “overestimating the cliff-edge” of Brexit according to Redeker.

The EU is more likely to be amicable in negotiations because it now has a greater incentive to agree a good deal for all, because of the possibility of a double-whammy threat of losing access to both the UK and US simultaneously, due to Trump protectionism.

They also cite seasonal factors kicking in to support Sterling due to the Tax year beginning in April.

Indeed, the Pound is considerably undervalued, according to SEB Bank’s chief FX Strategist Richard Falkenhall, who said in a recent note that, “By far, Sterling is the most undervalued of G10 currencies, in trade-weighted terms standing almost 20% below its long-term fair value.”

Nevertheless, despite this Falkenhall does not see the Pound rallying anytime soon due to the weight of Brexit uncertainty.

“So long as Brexit uncertainty – the reason for its present weakness – persists, a more substantial recovery is unlikely, although scope for further depreciation seems limited,” says Falkenhall.

Brexit Gets Real

The UK government has announced on Monday March 20 that it will trigger Article 50 on 29 March.

This will start a two-year process for the UK to negotiate its future relationship with the EU.

European Council President Donald Tusk meanwhile announced that he will present the draft Brexit guidelines to the EU member states within 48 hours of the UK triggering Article 50.

However, a detailed stance will probably take longer to formulate and real negotiations may not start until June.

"Recent statements on both the UK and EU side suggest both camps are taking a tough line, which is logical at the start of any negotiation process," notes Nick Kounis at ABN Amro in Amsterdam.

Prime Minister May has said the UK will not be part of the single market or customs union as she seems to want to start from a blank page so she does not need to negotiate under the current rules.

At the same time the EU has said they do not want the UK to ‘cherry pick’ the benefits of memberships, while getting rid of the responsibilities.

In particular, the EU insists that full access to the EU market is only possible with full freedom of labour.

"Our base case is that some balance between free trade, free movement and payments into the EU budget will be eventually agreed, though the outcome is obviously highly uncertain," says Kounis.