Pound to Slip towards 1.05 Against the Euro if these Conditions are Met

Above: Technical analyst Lucy Lillicrap at Associated Foreign Exchange.

Consensus amongst the analyst community is that the Pound to Euro exchange rate is likely to go lower in the wake of a flare-up in domestic political uncertainty, with some now even arguing the pair could plumb 1.05 before 2017 is out.

The Euro has been gaining ground against most leading currencies lately and that pattern continued last week against Sterling following the election result.

"The Pound posted a sixth consecutive weekly loss relative to the single currency and while this might have left it looking relatively oversold – its 14-day RSI has slumped to a reading of 34% - it is still not at all clear that the bottom is in," says Bill McNamara, an analyst with Charles Stanley, a brokerage based in London.

The next downside target being eyed by McNamara is now around 1.124.

For technical analyst Lucy Lillicrap, the prospect of Sterling-Euro falling to 1.05 is based on her studies of the structural shape of the market and historical precedent.

“Although an attempt to re-base hereabouts might yet be seen, the inability of prices to sustain above 1.2000 earlier this quarter suggests broader (incomplete) downtrends have now already resumed,” says Lillicrap in a briefing to clients of Associated Foreign Exchange - a foreign brokerage based in London.

Granted, this target is not as bad - if you want a stronger Pound of course - than that forecast scenario presented by UBS that suggests the pair could fall to 0.95 which is certainly the lowest projection we are currently aware of.

But, a spot exchange rate at 1.05 still delivers a retail rate below 1.0 in many scenarios which will seriously dent the purchasing power of those looking to trade with Europe.

Above: The longer-term move in the GBP/EUR exchange rate

Lillicrap is a technical analyst and therefore levels are important to watch as they hint at where buying and selling interest is likely to reside.

Often traders will enter and exit trades at pre-determined points based on their studies of previous price action.

Lillicrap believes that provided the exchange rate can hold itself above the 1.1245/55 area, then an extension back through secondary 1.1550/60 is seen as reducing immediate downside risk.

However, the analyst is overall negative on the outlook saying that should a downside breach of 1.1250 be engineered then current and recent market action will look increasingly top forming with subsequent potential to, if not beneath, 1.1000 as well.

“Technical studies currently favour lower prices for GBP/EUR … objectives lie at 1.1000 and then 1.050,” says Lillicrap.

The Hangover from the Hung Parliament

We saw Pound Sterling suffer a notable dip on June 8 and 9 after the UK electorate gave Theresa May a win in the General Election, but it was an unconvincing one that has seen doubts grow over the longer-term stability of the UK economy.

Above: The latest weekly FX market view from AFEX considers the implications of the UK's recent election

The slide in the Pound is expected to see some follow-through.

Concerning levels the Pound might go to, "the best playbook for the Pound under a hung parliament is the 2010 election," says analyst Viraj Patel at ING Bank.

"GBP/USD continued to fall in the days after the election as major parties scrambled around to form a coalition."

Under a similar environment in 2017, ING won't rule out GBP/USD falling to as low as 1.24 and EUR/GBP moving up towards 0.90."

EUR/GBP at 0.90 means a fall to 1.11 in GBP/EUR.

New research from UniCredit Bank also singles out the 1.05 area as a potential target.

Analysts at the Italian bank point out that during the years of the Eurozone debt crisis (2010 to 2012) the UK experienced a surge of portfolio inflows as growth was firming and the economy was perceived to be a safe haven amongst G10 countries.

"But this has changed since the Brexit vote: indeed, balance of payments data for 4Q16 show that foreign portfolio investment is going into reverse. This process should gain more traction now that domestic political risk premia rise even further," says UniCredit's UK economist Daniel Vernazza.

As a result, UniCredit say their already bearish GBP forecasts (GBP-USD at 1.28 and EUR-GBP at 0.89 by year-end) "are now subject to deeper Sterling downside risk".

Note that EUR/GBP at 0.89 equates into a Pound to Euro exchange rate at 1.1236.

UniCredit see a fairly good chance that EUR/GBP rises to 0.90 rather swiftly and potentially towards 0.95.

In Pound to Euro exchange rate terms this equates to 1.11 and 1.0526.

Pre-election rate spreads suggested that Pound Sterling was actually looking expensive against the Euro.

"With the prospects now that over the next few weeks UK yields come under increasing pressure and Gilt-Bund spreads narrow even further, more upside for EUR-GBP seems inevitable in our view," says Vernazza.

"And to the extent that over the medium term U.K. yields rise as a reflection of elevated risk premia, any potential re-widening in the spread is unlikely to offer support to Sterling. Both short-term and medium-term GBP's prospects appear daunting to us."

Significantly Stronger Euro seen in 2018

While Sterling weakness is liable to do the majority of damage to the valuation of the GBP to EUR conversion, one must not forget the Euro in all this.

And again, unfortunately for Sterling bulls, the picture here is one that hints at Euro strength going forward.

In fact we could see 'significant' strength according to analysts at Société Générale.

Expectations for a notable Euro appreciation have grown as the Eurozone economy improves and analysts expect the European Central Bank to stem their stimulus programme in response.

In their mid-year review of foreign currency markets Société Générale’s most notable call is one that sees the potential for significant appreciation in the Euro which could jump like a “Jack in the Box when the lid starts opening,” says Juckes.

Interest rate volatility fuelled by central banks exiting accommodation will be channelled towards FX. In the process, the EUR/USD skew could flip in favour of EUR calls for the first time since 2009,” notes the strategist in a note to clients.

Strength in EUR/USD will certainly drag EUR/GBP higher as they do tend to move mirror each other.

'Calls' are options which appreciate when a currency rises and so indicate a bullish outlook for EUR/USD – with a target an end of year target at 1.20 according to the strategist.

1.20 may even be a conservative estimate according to Juckes' colleague Oliver Corbier, who sees the possibility of move up to 1.30  based on, "technicals, undervaluation, EA strong capital surplus and the ECB withdrawing from QE," which are, "strong forces that may propel the euro much higher than our 2018 forecasts."