The Pound-to-Euro Exchange Rate: Major Repricing Key Risk at Impending BofE Meeting

The stance adopted by the Bank of England on Thursday could deliver a major repricing of Pound Sterling's value against the Euro argue analysts.

Thursday’s Bank of England meeting could yield a major repricing of the Pound-to-Euro exchange rate warn strategists at TD Securities.

Analysts suggest the Bank's Monetary Policy Committee might adopt a more 'hawkish' tone in response to the latest fall in Sterling against the Euro and any renewed acceleration of inflation.

'Hawish' refers to a central bank or central bankers who are intent on raising interest rates or withdrawing stimulus.

Such a move would catch markets by surprise owing to the pervasive dour sentiment adopted by economists and traders towards the UK economy and currency.

The British Pound has risen against both the Dollar and Euro through the course of August as traders cut back on their negative bets towards Sterling in anticipation of the Bank delivering a potential surprise.

The decision of the MPC is delivered on Thursday at 12:00 pm London time.

Traders will watch the vote split for signs of an overt shift in sentiment on the committee, which returns to its full nine man strength for the September meeting, but will also scrutinize the policy statement closely for indications of a hawkish turn in the language of policy makers.

“An unexpectedly hawkish outcome risks a major repricing... This leaves EUR/GBP exposed to significant positioning risks,” says James Rossiter, a London-based foreign exchange strategist at TD Securities. “Cable (GBP/USD) could surge to fresh post-Brexit highs in the weeks ahead amid a broadly weaker USD.”

In particular, the vote of Chief Economist Andy Haldane could be key we know he is wavering on his support for keeping interest rates unchanged. Should Haldane vote for a rate rise it would send a strong signal to markets that higher rates lie ahead.

Sterling would likely find further upside impetus in such an event.

Crucially, for such an outcome to be achieved, August inflation numbers must point to a fresh acceleration in inflation. 

The ONS releases August inflation data at 09:30 London time Tuesday with data expected to show headline consumer prices rising at a rate of 2.8%.

Such an outcome would mark a departure from the deceleration seen in July and a return toward the cyclical peak of 2.9% set back in May.

The BoE has spoken before of the need to balance its mandate to target inflation of 2% with its other mandate to create the conditions necessary to support growth.

Inflation that threatens the 3% level might just be enough to bring about a change of rhetoric - even if it is only rhetoric that changes it could still have a notable impact on the value of the Pound.

“Tuesday’s UK inflation reading will help crystalize expectations for the September MPC meeting. There, we see slight upside risks to the market’s current consensus forecast for an uptick to 2.8% y/y on the headline CPI report for August,” says Rossiter.

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Bank of England Needs a Stronger Pound

The Bank of England is wary that a falling Pound risks stimulating fresh inflationary pressures as the cost of imports are foreced higher.

A trade-weighted measure of Sterling's value shows a 3% decline in August, thanks largely to the decline in GBP/EUR.

By keeping a floor under Sterling, the Bank would be taking a step in ensuring the 3% ceiling in inflation is not broken.

Analysts at Barclays say they believe a 'hawkish' Bank of England will tailor their tone to support the Pound.

"We expect the Bank of England to keep its policy settings unchanged this week while seeking to support the currency with more hawkish rhetoric. Recent GBP weakness adds upside risks to the bank’s inflation forecasts, giving fresh ammunition to the MPC hawks calling for an immediate rate hike," says a note from the Barclays currency strategy team ahead of the event.

TD Securities' base-case forecast is for the MPC vote to split with seven in favour of remaining on hold and just two in favour of a hike which should garner a broadly neutral reaction from the market.

But, Rossiter is clearly wary of a surprise:

"Any pick-up in activity or underlying inflation momentum, or a breakthrough in Brexit negotiations, could renew pressure on the MPC to reverse last year’s emergency cut."

Any surprise by the Bank leaves Pound and Euro exposed to significant positioning risks; the latest data on market positioning by the CFTC shows pro-Euro bets are at elevated levels which exposes the currency to a potential reversal should traders look to exit the bet.

Traders meanwhile hold net bets for further Sterling weakness, and any shift in sentiment could trigger a positioning reversal by the trading community which would generate GBP/EUR upside.

The Bank of England could well provide such a trigger.

"Our key risk scenario is for this meeting is for a third dissenter to emerge in favour of a hike. Were this to occur, we think sterling could see a significant repricing across the spectrum of G10 currencies," says Rossiter.

The Pound-to-Euro exchange rate rose by 0.25% during early trading in London Monday, bringing gains for the pair during the last week to 0.66%, although this still leaves the British currency 6.3% offside against its European rival.

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