How the ECB Can Spoil Pound Sterling's Bull Run Against the Euro
- Written by: Gary Howes
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Above: File image of ECB President Christine Lagarde. Copyrights: Angela Morant/ European Central Bank.
Pound Sterling's run higher against the Euro will be tested by the European Central Bank (ECB) today.
The ECB will cut interest rates by at least 25 basis points, although market pricing shows a 15% expectation that it may go bigger with a 50 basis point cut.
The scale of the cut will be the initial trigger to moves in euro exchange rates. Because a 50bp cut is underpriced, the euro would fall in a knee-jerk reaction.
Here, the Pound to Euro (GBP/EUR) exchange rate could hit new 2024 highs above Wednesday's peak at 1.2158.
"Markets may interpret a 50bp cut as a signal of a lower terminal rate - and that may even be a signal that the ECB wants to send," says Magnus Poulsen, an analyst at Danske Bank.
"Terminal" refers to the level at which the ECB ends the cutting cycle. The lower the terminal level, the more pressure the Euro would likely come under during the cycle.
W. Brad Bechtel, Global Head of FX at Jefferies, explains that relative interest rate expectations between the ECB and Bank of England are why the GBP/EUR punched through to a new cycle and year-to-date high. "It's a simple rate divergence story for EUR/GBP as it is pretty clear the BoE will remain well behind ECB on pace and above ECB on terminal."
Goldman Sachs point forecasts for 2025 are out, showing ongoing resilience for GBP/EUR. But how high can the exchange rate go? Find out more.
Although the direction of travel favours further GBP outperformance of the EUR on account of central bank action, the ECB is more likely to settle for a more economical 25bp cut today, having noted that inflation picked up again in November.
Given that it is already expected, the Euro would see limited movement on such a decision and the euro could even strengthen.
There is a strong possibility that the rise in GBP/EUR over recent days is an example of markets front-running the ECB decision.
This behaviour opens the door to a "buy the rumour, sell the fact" reaction to the decision. For this reason, an unremarkable day at the ECB could yet see a relief rally in the euro and a fall for GBP/EUR.
Under a 25bp cut, traders will quickly turn to the language in the ECB's guidance for clues on how fast and far the ECB tends to move in 2025.
If the ECB makes clear it is committed to delivering more cuts, whatever the data, the euro can come under pressure.
However, the euro would strengthen if the ECB maintained its recent guidance that policy must be restrictive for as long as necessary to sustainably bring inflation back to 2%.
Such language would signal that the ECB remains data-dependent and is not yet ready to commit to forward guidance that guarantees further interest rate cuts, whatever the bumps in the inflation path.
Here, the euro can recover and undergo a relief rally and GBP/EUR would potentially dip back below 1.21.
New economic forecasts will also be of interest.
"We think there could be some downward revision to growth and perhaps even inflation forecasts today," says Chris Turner, an analyst at ING Bank. "Dropping the 2025 forecast closer to 2.0% could potentially lay the path for an accelerated easing cycle."
In September, the ECB set inflation forecasts at 2.5%, 2.2% and 1.9% for 2024, 2025 and 2026 respectively. It said annual average real GDP growth would be 0.8% in 2024, 1.3% in 2025 and 1.5% in 2026.
"If we see a downgrade in the ECB's economic growth outlook, markets may weaken the EUR," says Thanim Islam, Head of FX Analysis at Equals Money.
