The Pound to Recover Further vs. Euro say Nomura Strategists Eyeing Mismatch on BoE Expectations

Strategists eye further ~2% advance in the Pound-to-Euro exchange rate on belief Bank of England is about to initiate a new cycle of interest rate rises.

Pound Sterling rallied 1.0% against the Euro in the week October 23-27, and the move might have further to go if the hunch of Jordan Rochester, Global FX Strategist with Nomura - the global financial services provider - are correct.

Rochester and his team at Nomura have been tactically bullish on Sterling against the Euro for some time now, but reiterate their stance ahead of a key month for the British Pound in which the Bank of England delivers its first interest rate in ten years. 

On Thursday, October 2 the Bank of England's Monetary Policy Committee meet to decide on whether or not to raise interest rates while the Bank also releases the latest economic forecasts from their analysts.

Markets are pricing a 0.25% interest rate rise as a near-certainty; hence the interest rate rise alone will have minimal impact on the Pound’s valuation. What matters is the communication offered by the Bank regarding future interest rate rises.

Should more rises in 2018 be hinted at, the Pound should rise, should the Bank say this is certainly a one-off, expect the Pound to fall.

Nomura are betting that the Bank is at the start of a slow cycle of rate rises, hence they are expecting some degree of Sterling strength.

“It is not clear to us that UK growth is about to falter suddenly. There may be further Brexit negotiation uncertainty, but there is arguably a lot of it already. Instead, we prefer to trade with conviction the idea that this is not a policy mistake and that the BoE is on a hiking cycle,” says Rochester.

Nomura observe “a sizeable proportion of commentators” judge the Bank of England hike to be about to make a “policy mistake” by raising interest rates. The argument being that the UK economy is slowing and raising interest rates will only add pressure on consumers and businesses.

The idea of a ‘policy mistake’ remains fresh for such commentators who remember the ECB’s policy mistake in 2011, when rates were raised twice by the ECB. European economic growth subsequently stalled and the continent’s debt crisis deepened, which created fresh problems for markets around the world.

"For investors, the key question is whether or not there will be further hikes next year. Market expectations are for at least one further 25bp hike next year. In contrast, we think the MPC will be making a mistake by hiking now, and that they will recognise this in the coming months,” says Daniel Vernazza, UK economist at UniCredit.

But Nomura argue the UK of 2017 - even with Brexit uncertainty being present - is different to the Eurozone of 2011 when the region was facing significant structural problems that were hangovers from the financial crash of 2008, the subsequent recession and then the Eurozone sovereign debt crisis.

Indeed, Nomura economists acknowledge trend rate of GDP growth is likely to be slower now than in the past, “meaning that a lower rate of growth is needed for slack to be eroded now relative to the past.

But, “we prefer to trade with conviction the idea that this would not be a policy mistake and that the BoE is on a hiking cycle,” says Rochester.

How High Can the Pound Go?

Turning this view into a tangible view on Sterling’s direction, the question becomes, how far can the exchange rate move?

“We still have a tactical EUR/GBP short in place where we are targeting 0.87,” says Rochester; this gives us a target on GBP/EUR at 1.15.

Much will depend on the tone struck by the Bank of England - indeed, for Sterling to go higher it is key that further interest rate rises are hinted at. Or, at the very least, they are not entirely ruled out.

From a technical perspective we note Sterling-Euro is comfortable trading within a band that has been in place for over a month now.

Sterling has been advancing against the Euro since October 20, the move higher taking the exchange rate back into the middle of a wide band that it has inhabited since mid-September:

Further gains towards the top of the band towards 1.1430 are not inconceivable, however our technical analyst Joaquin Monfort has his eyes on a rate a little lower than here, his views can be found in his latest week-ahead report.

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