The Pound Sterling continues to make headway in the market, with the currency gaining some traction over the month. The Pound to Euro (GBP/EUR) exchange rate started the year hovering around 1.13 but has seen record highs of 1.1724 before a slight correction to 1.17.
While most investment banks believe that the current rate estimate for the Bank of England is too high, others view additional GBP/EUR advances as possible.
UK inflation: Pound Sterling will continue to be backed by the Bank of England
The recent release of inflation data in 2023 has notably impacted the Sterling markets in trading forex, prompting active responses. Recognising the gravity of inflationary pressures in the UK, the Bank of England increased interest rates by 50 basis points.
Market analysts highlighted that this move was crucial to safeguard the Pound's gains in 2023. Consequently, the Pound displayed its characteristic volatility following the decision. Nevertheless, it managed to hold its ground against the Euro and other major currencies, despite the continued strength of the US Dollar, which showed signs of recovery.
The Monetary Policy Committee (MPC) demonstrated a strong "hawkish" signal by voting 7-2 to raise the Bank Rate by 50bp to 5.0%. The committee acknowledged that the second-round effects of external cost shocks on domestic prices and wages were likely to take longer to subside than to emerge. Recent data revealed upside news indicating a persistent inflationary process, given the tight labour market and continued demand resilience, as stated by the Bank in an official statement.
The Bank further emphasised its commitment to a data-driven approach by confirming its readiness to raise interest rates further if warranted by future data. However, a significant downside risk for the Pound lies in the possibility that the substantial increase in interest rates could trigger a sharp slowdown in economic activity over the next few months, leading the Bank to implement significant rate cuts.
Considering the current circumstances, there are risks associated with adopting a more hawkish stance after the swiftest rate-tightening cycle since the 1980s. The economy faces a potential recession as we approach 2024, given the looming "mortgage squeeze" and a shift in the credit cycle.
In the short term, elevated expectations regarding Bank of England rates suggest that the Pound will continue to enjoy broad support, enabling it to maintain its recent multi-month highs against the Euro.
Eurozone inflation declines but slumps on "dreadful" Eurozone PMI release
In May, the latest Eurozone data unveiled a decline in the headline inflation rate, reaching a 14-month low of 6.1%. This figure marked a decrease from April's 7.0% and fell below the consensus forecasts of 6.3%. Moreover, the core rate also declined, dropping to 5.3% from 5.6% and falling short of the expected 5.3%.
These figures provided relief regarding the inflation outlook, indicating a downward trend. However, according to S&P Global's monthly PMI survey, the Eurozone's economy faced the risk of contraction in June, with the region's economic upturn losing momentum. We also saw a decline in new business orders for the first time since January.
The Services PMI for June stood at 52.4, lower than the market's anticipated level of 54.5. This movement represented a significant downside miss, signalling a sharp slowdown compared to May's impressive figure of 55.1.
Pound Sterling forecasts against Euro revised higher at Bank of America
The Bank of America has adjusted its Pound forecasts, expressing confidence that the UK currency will continue to receive support, even in the face of a "grim fundamental outlook" for the UK economy.
Traditionally, the Bank of America has been pessimistic about the Pound, expecting it to consistently underperform due to the sluggish growth of the UK economy in 2023. However, recent economic performance has surpassed consensus expectations — leading to positive surprises in data — resulting in higher UK bond yields and a stronger Pound.
Bank of America's foreign exchange research note acknowledges the perplexing solid performance of the Pound despite the gloomy outlook of weak growth and elevated inflation. The note attributes the Pound's resilience to the fact that UK data has exceeded meagre expectations.
The research report outlines the Bank of America's mid-year currency market assessment, including several forecast revisions. One notable revision is a downward adjustment in their projection for the EUR/GBP exchange rate. They had previously anticipated a gradual increase towards 0.91 in the long term, but now they expect EUR/GBP to hover around 0.85 until the end of their forecast period in 2024. The last Pound to Euro forecast of 1.0980 has been revised upward to 1.1765.
The analysts anticipate that the Bank of England will continue to act as a supportive force for the Pound by implementing further interest rate hikes to combat inflation.
We can attribute the recent strengthening of the Pound to positive developments in the June ONS labour market report. This report revealed an unexpected decline in the unemployment rate and stronger-than-anticipated growth in job creation and wages, confirming the persistent tightness in the labour market. Economists believe that the rise in wages will result in stubbornly high UK inflation in the foreseeable future, prompting the Bank of England to take countermeasures such as raising interest rates further.
Forecast for Q3 and Q4
GBP/EUR may rise due to persistent inflationary pressures in the UK, leading the Bank of England to extend its tightening cycle. The growing speculation that the Bank of England would continue to raise interest rates even after the Federal Reserve and the European Central Bank (ECB) have completed or have only one more rate rise remaining might be helping the British Pound.
Weakening inflation and a weakening economy would cause the ECB to reconsider how far to raise interest rates. To be sure, at least one more rate rise is on the way, based on ECB Governing Council members' recommendations, but beyond that, questions remain. The European Central Bank (ECB) should pause soon and reevaluate the GDP and inflation prospects as most of the effect of rate rises is still in the pipeline.
If the market believes this is the likely path for the Eurozone, the Euro might face pressure. We still expect the GBP/EUR to fall later in the year.
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