Pound Sterling Set for a Long, Deep Decline against Euro and Dollar Says Commerzbank Eyeing Bank of England Credibility Issues

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Commerzbank, a leading financial institution, has warned in a mid-year update that Pound Sterling is poised for a prolonged and significant decline against both the Euro and the Dollar. 

Although analysts at the Frankfurt-based bank failed to predict the Pound's outperformance in 2023 (see below) they remain staunch bears on the UK and its currency, particularly in the wake of the Bank of England's (BoE) recent interest rate hike, which failed to bolster the currency.

In a midyear forecast update, Commerzbank says the Pound is likely to fall below 1.20 GBP/USD and 1.11 GBP/EUR as the Bank of England is expected to face continued credibility issues in its fight against inflation.

In May, consumer price inflation in the UK remained unchanged at 8.7%, defying expectations for a more pronounced drop with core inflation surging from 6.8% to 7.1%, indicating persistent price pressures.

"The shock of the inflation data must have hit hard and there is likely to be growing scepticism about whether the BoE has done enough so far and will be able to get inflation under control," says You-Na Park-Heger, FX Analyst at Commerzbank.

The Bank of England responded to this inflation surprise by implementing a 50 basis points hike, raising the interest rates to 5%. Surprisingly, says Park-Heger, the Pound did not benefit significantly from this decision, leading to mounting doubts about the central bank's efficacy in addressing inflation concerns.

Indeed, UK two-year bond yields have advanced to levels not seen since 2008 but the Pound to Euro exchange rate is set to record a second consecutive weekly decline. Meanwhile, the Pound to Dollar exchange rate also ended the week of the Bank's interest rate decision with a loss and looks set to follow suit with a second consecutive weekly decline.

At a bare minimum, the Pound is struggling to reboot its recent trends of strength despite the Bank's bigger-than-expected hike.

You-Na Park-Heger says the market's reaction to the Bank's rate decision is that it was not "convincing."

Moreover, the BoE's forward guidance did not provide a clear trajectory for interest rates. The central bank maintained a cautious stance, leaving the rate outlook open-ended.

Park-Heger notes, "the fact that the BoE explicitly refers to the fact that 'at this meeting, the Committee voted to increase Bank Rate by 0.5 percentage points, to 5%' suggests that the same might not apply at the next meeting."

This ambiguity casts doubt on the central bank's commitment to combating inflation through proactive monetary policy measures.

Commerzbank's analysis emphasises the perception of a central bank that has been slow to react and has taken smaller rate steps too early.

Park-Heger remarks, "the BoE seems to be chasing inflation developments rather than fighting them with an active monetary policy, which is damaging for Sterling."

The cautious approach adopted by the BoE is likely to weigh on the Pound's performance, particularly in relation to the Euro.

Commerzbank forecasts the EUR-GBP exchange rate will surpass 0.90 in the coming quarters.

Furthermore, Commerzbank anticipates that the BoE will eventually reverse its tightening cycle and begin cutting interest rates next year, a move that could further undermine the Pound's strength.

In contrast, the European Central Bank (ECB) is expected to maintain its key rate, displaying a relatively more hawkish stance compared to market expectations. This divergence in monetary policy is likely to support the Euro, exacerbating the challenges facing the Pound.

Commerzbank's forecast profile for the Euro-Pound sees 0.90 by the end of September, 0.91 by year-end, 0.91 by the end of March 2024 and 0.92 by the end of June 2024. By year-end 2024 a forecast of 0.93 is pencilled in. This gives a Pound to Euro profile of 1.11, 1.10, 1.10 and 1.09 and 1.08.

For the Pound to Dollar rate, the forecast profile held at Commerzbank is 1.24, 1.25, 1.23 and 1.20 for the aforementioned points in time, with weakness extending to 1.18 by September 2024 and 1.16 by end-2024.

Looking at Commerzbank's track record reveals back in January analysts had forecast the Pound-Dollar exchange rate would be at 1.18 by June 2023, whereas spot is now closer to 1.28 as month-end approaches. For Euro-Pound the January forecast was for 0.90 by June (1.11 GBPEUR), whereas spot is currently at 0.86 (1.1620).