Pound-to-Euro Exchange Rate Forecasts Poised for Upgrade at Rabobank

- An upgrade to GBP/EUR forecasts at major European bank eyed

- Euro's key risk event is impending Italian budget

- But Pound in need of 'sustenance' and therefore unlikely to run riot

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The Pound-to-Euro exchange rate is still forecast to fall into the Autumn period by analysts at pan-European investment bank Rabobank. However, a new note from the Amsterdam-based institution has informed clients that they might consider raising their forecast on account of perceived Italian risks and they see the next potential flash-point for the country being the announcement of the new government's budget.

Rabobank have warned "the budget promises of Italy’s new government are set to re-shape the perceived risks associated with the EUR, which could dominate market focus over the summer."

The Euro slipped against its major rivals on Tuesday, March 5 as Italian Prime Minister Giuseppe Conte unveiled what will be the new coalition government's agenda in an address to the Senate ahead of confidence vote that it is expected to win.

Conte told newly sworn in lawmakers that Italy's debt, which is equivalent to nearly 130% of gross domestic product, is "today fully sustainable" but that the state needs to reduce it by growing the economy. He also said fiscal policy and public spending must be aimed at "ensuring stable, sustainable growth".

Markets had expected the British Pound to be most vulnerable to political risks over the summer and Autumn period as the UK and EU attempt to thrash out a Brexit deal, but for Rabobank the additional worry posed by a Rome-Brussels clash over the Italian budget now forces the GBP/EUR exchange rate between "a rock and an hard place".

"Even though Brexit-related uncertainty is GBP negative, upside potential for EUR/GBP may be limited if investors anticipate a defiant tone from Italy’s populist government," says foreign exchange analyst Jane Foley at Rabobank's London office.

The Next Italian Risk is the Budget

Rabobank reckon the aims of Italy’s new populist government "still appear decidedly Brussels-unfriendly."

Cited are the new administration's stated policy to demand to "revisit" the EU’s seven year budget "with the aim of making it consistent with the government contract".

The government's policies include an universal basic income and lower taxes, which seem at odds with the EU fiscal straitjacket which has been designed to harmonise Eurozone finances and give the currency bloc a chance at functioning.

"We don’t know how accommodating the EU will be to the new government, but one possibility is that they call for greater structural reforms in return for more fiscal breathing space," says Hann-Ju Ho, Senior Economist for Commercial Banking at Lloyds Bank. "What is less uncertain is that critical long-term challenges for the economy remain unresolved."

Rabobank estimates suggest in a "worst case scenario" the new Italian government’s policies would need additional financing of between EUR100BN and EUR152BN a year.

This equates to around 5.8% and 8.8% of GDP and is set against a backdrop of a huge debt pile in the region of 133% of GDP.

"A stand-off between the Italian government and Brussels on the budget thus looms. Given the risk that anti-EU sentiment could extend in Italy, this does not present a positive environment for the EUR," says Foley.

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The British Pound Needs Fresh Sustenance

While we have seen expectations for the Euro's outlook take a knock thanks to Italy, many analysts have been loath to bump up their forecasts for the GBP/EUR exchange rate owing to Brexit uncertainties.

Add to this a slow economy and a Bank of England unwilling to raise interest rates, and its easy to conclude the fundamental underpinnings driving Sterling's valuations are hardly inspiring.

Foley says the British Pound "needs fresh sustenance" if it is to making a convincing advance on the Euro and in terms of Brexit, the economy and Bank of England there is little hint that such sustenance will be made available.

"Barring some upward surprises in economic data, policy makers will have little scope for action and the outlook for GBP will remain grim," says Foley.

However, there are expectations for the UK economy to pick up some pace over coming weeks and months, indeed the first two PMI releases of June suggest the economy is indeed finding its feet, with both releases beating consensus expectations.

"In our view, a rate rise in August remains a distinct possibility if, as we expect, economic growth recovers and CPI inflation starts to rise again in the next few months," says Lloyds Bank's Ho.

GBP/EUR Forecasts Could be Upgraded

While there are some signs of light ahead for the UK economy, that perpetual niggle for Sterling remains: Brexit.

While the outlook for the Euro has certainly soured, "anxiety about a lack of clarity on the future trading arrangement between the UK and EU had the potential to weaken the Pound and push EUR/GBP towards the 0.89 area by the autumn," says Foley.

This gives a GBP/EUR forecast of 1.1236, which is actually now a mere 1.36% from the spot exchange rate witnessed at the time of writing.

In short, downside in the exchange rate is therefore limited, but thanks to growing risks in the form of Eurozone politics, Rabobank's forecast might actually be upgraded.

"The risk of a stand-off between Rome and Brussels on Italy’s budget brings in some downward risk to this forecasts," says Foley of the potential for a downward revision to the EUR/GBP target i.e. an upgrade to the GBP/EUR target.

"We have already revised lower our EUR/USD forecast to 1.12 from 1.15 on the back of Italian politics and we will be watching events closely in the coming weeks with respect to the outlook for EUR/GBP," adds the analyst.

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