Pound Sterling Rally vs Euro Reaching its Limit say Nordea, See "Herd Behaviour" Behind Pound's Moves

The Pound-to-Euro exchange rate is forecast to reach its limits as the tail-winds provided by the Bank of England being to fade.

The outlook for Sterling turned 180 degrees when the Bank of England communicated they were giving careful consideration to raising interest rates.

The news saw the Pound move higher against a host of major currencies and in the process formed what appears to be a solid base to the post-EU referendum declines.

The promise of higher interest rates makes for a stronger Pound as the improved yield on monetary assets attracts more inflows of foreign capital.

While many in the market have turned notably more optimistic on the Pound’s outlook, others warn against exuberance.

Andreas Steno Larsen at Nordea Bank says markets have now seemingly switched from, "exaggerated pessimism regarding the Sterling," to "exaggerated optimism.”

Larsen beieves the support provided by the Bank of England is likely to fade as inflation is expected to be constrained at 3.0% by the strengthening Pound which should in turn mean the Bank of England retreats from further interest rate rises.

Indeed, many are suggesting that the Bank is only raising rates to boost the Pound which will in turn push down the cost of imports and cap rising inflation.

“Neither from the inflation prints, nor the pricing of Bank of England do we see any scope in expecting Sterling positive news in to 2018 (at least on the other side of the hike in November)," says Larsen.

Nordea have fine-tuned their call on the Bank of England and now expect the one and only hike in November 2017 instead of Q1 next year.

"This change is in line with recent signals from the bank. The rate hike should not be seen as the start of a tightening cycle. Rather it would be a tentative withdrawal of some of the stimulus that was provided after the 2016 EU referendum. Longer out we expect the slowing real economy to pull inflation below target, and the Bank of England is therefore expected to leave its policy rate unchanged throughout the rest of the forecast period," says Larsen.

We take Larsen's view seriously, recalling his scepticism for those forecasts that said the Pound would fall to parity against the Euro.

The analyst believes the Pound is currently subject to "herd behaviour" in the markets, of which the current recovery is no exception.

The analyst is also sceptical that politics have shifted enough to warrant more positivity towards Sterling.

Larsen is negative about Theresa May's non-committal Brexit pledges made in Florence, which he characterises as, "poisonous for the GBP."

It is also suggested that May may meet her 'end' even during the Conservative party conference between October 1-4, however we see this risk as being limited.

Seasonality Might Help the Pound

But scope for downside decline is limited with support for Sterling against the Euro coming from a curious link to Dollar liquidity.

Seasonally, the US Dollar rises towards the end of the year due to tightening liquidity as a result of "regulatory effects", however, this is much more pronounced against the Euro, in EUR/USD, than versus the Pound in GBP/USD.

As a consequence the Pound-to-Euro cross normally rises at the same time, towards the end of the year.

Yet another positive influence for Sterling is the British economy's tendency to do a lagged impression of the US's, due to a common 'Anglo-Saxon' link.

"And while macro momentum looked kind of depressing in the UK over the summer, the good old Anglo-Saxon connection still seems to prevail in terms of key figure momentum. Better US data spills over to better UK data within a few months. And with current surprises to US macro momentum moving in a positive direction, we should expect the UK to follow suit in Q4," says Nordea.  

Taken together with the positive impact of the now heavily expected November rate hike, this would seem to suggest that the Pound could hold its own in the remainder of the year, but then weaken in 2018.

However, Nordea's Larsen is actually more pessimistic about the Pound arguing the positives will be more than eclipsed by Brexit uncertainty as GBP/EUR will probably fall in Q4.

"All-in-all we don’t have a strong directional view on EUR/GBP before year-end, but see risks mainly tilted to the upside as the i) Low probability of further upside to Bank of England pricing and inflation will counter effects from ii) tighter USD liquidity and iii) A higher UK surprise index," says Larsen.

Nordea Markets are forecasting the Pound to end 2017 around 1.09-1.10 against the Euro. The exchange rate is forecast to rise to 1.15 towards the middle of 2018.

Get up to 5% more foreign exchange by using a specialist provider by getting closer to the real market rate and avoid the gaping spreads charged by your bank for international payments. Learn more here.