Pound Euro Exchange Rate (GBP/EUR) Surges on ECB Rhetoric, But Then Falls Back Again

The British pound (GBP) hit one month highs against the euro following the November policy meeting and press conference at the European Central Bank.

The outcome of the event was initially negative for the euro; this allowed the pound sterling to push higher above the 1.28 pound to euro exchange rate marker.

However, the euro then staged an impressive comeback rally to ensure the pound is no better than it was at the start of the week.

A further potential threat to the GBP/EUR rally still lies ahead with the Bank of England featuring twice in November - the policy meeting on Thursday and the all-important November Quarterly Inflation report (QIR) on the 12th November.

It is this qaurterly meeting that could hurt the GBP against the EUR the most warn analysts at Bank of America Merrill Lynch.

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ECB Sinks the Euro, Which then Recovers

There was ultimately no substantial basis to the declines in the Euro on Thursday.

“It’s not clear exactly what triggered the move, given the outcome was largely as expected. The only notable change was the statement that indicated that the ECB ‘has tasked ECB staff and the relevant Eurosystem committees with ensuring the timely preparation of further measures to be implemented, if needed’” say Lloyds Bank Research.

The market may have taken this as a hint that there could be more measures to come.

Kathy Lien at BK Asset Management tells us that ultimately the EUR will remain under pressure:

“The trade in FX still centers around policy divergence and in Draghi's own words, the ‘main message’ today is that "ECB assets will expand as others contract."  As long as there is a risk of additional easing from the ECB, the euro will remain under pressure.”

The euro hits fresh 2 year lows against the US dollar and one month lows against the pound after Draghi said his team are unanimous on the need for more stimulus if needed.

Markets sold the euro further when he warned of lower forecasts for the Eurozone and said ABS buying is to begin soon.

"USD demand has emerged across the board as ECB President Draghi starts his verbal intervention, There seems no reason to buy EUR at all; even if the ECB doesn’t introduce QE or provide additional measures, the Eurozone looks like it’s in deep trouble," says Milan Cutkovic at ForexTell.

Further action to be taken in case of a deterioration of the price outlook or if inflation expectations worsen.

The ECB also confirmed that balance sheet expansion is very important for the ECB.

Indeed, it has been communicated that staff are conducting further studies on possible additional measures.

"We believe that measures already taken will have the effect we intend, but the outlook could worsen," says Draghi.

The Euro Rallies on Draghi Leadership Woes

It was only a day earlier when the assumption that the euro will weaken as the European Central Bank (ECB) embarks on an irreversible road of policy easing was questioned sparking a fresh rally higher in the euro exchange rate complex.

Eurozone central bankers, who set policy at the ECB, plan to challenge European Central Bank chief Mario Draghi on Wednesday over what they see as his secretive management style and erratic communication and will urge him to act more collegially, ECB sources told Reuters.

The report says Draghi effectively set a target for increasing the ECB's balance sheet immediately after the policy-making governing council explicitly agreed not to make any figure public.

Irritation among national governors who hold a majority on the 24-member council could limit Draghi's space for bolder policy action in the coming months.

Why the Quarterly Inflation Report Could Hurt the Pound Euro Rate Near-Term

Analysts doubt the November BoE meeting will have a meaningful impact on GBP as the focus is squarely on the QIR.

UK money markets and exchange rates have been seen adjusting lower in anticipation of the possibility of a dovish slant to the Report.

Aiding this caution has been a host of dovish BoE comments warning that the time is not right to raise interest rates.

Markets are currently seen pricing the first first UK rate hike for the third quarter of 2015.

Nick Bate at Bank of America Merrill Lynch Global Research has said there is a chance that sterling could weaken in the immediate aftermath of the QIR, but a strong close to 2014 should be expected:

"With UK rate differentials versus G10 having stabilized and once again providing support for GBP and as financial markets recover from their moment of mid-October madness, we continue to look for GBP to end the year on a strong note.

"The Quarterly Inflation Report provides a prospective speed bump to the recovery in GBP versus EUR, but the relative fundamental backdrop to the UK remains a strong one despite the recent push back in our timing on UK rate hikes."

Bank Prepares Markets for a Sheepish Quarterly Inflation Report

Turning to the November meeting of the Bank of England's Monetary Policy Committe on Thursday the 6th markets are overwhelmingly poised for no changes to policy to be announced.

"The decision will be heavily influenced by the forthcoming November Inflation Report projections (12 November), and in that context, we think comments from various BoE members recently seem to be preparing the ground for a more dovish outlook," says Bate.

For example, Deputy Governor Jon Cunliffe judged that softer wage and inflation data, along with a weaker external outlook, suggested that monetary policy could remain looser for longer.

"In a similar vein, Chief Economist Andrew Haldane judged that his view of the outlook had become gloomier in recent months, and Deputy Governor Minouche  Shafik did not push back against a press question suggesting that she was not at all close to voting to raise rates," Bate tells us.

BUT - Danger That Markets Are Overly Pessimistic on Sterling

There is the danger that money markets have under-estimated the UK economy (as highlighted by the recent release of UK Manufacturing PMI) and therefore may be mis-timing the first UK rate hike.

If this is true then the GBP will push higher against the euro and the attainment of the 1.30 level in GBP/EUR will become possible.

TD Securities warn that the Bank of England is in fact likely to raise interest rates in Feburary:

"We continue to maintain our 2015 calls for the Fed to begin hiking in September and the BoE to begin in February. The Fed has longer to make up for lost ground while for the BoE, there is a checklist of key events which must be met in the coming weeks to keep this on track.

"But markets may have now overshot on global growth fears, and both banks are being driven more by broad labour market dynamics rather than point estimates for just low current CPI."