Pound-to-Euro Forecasts Over Next 6-12 Months: Where Next For GBP/EUR Exchange Rate Buyers?

Pound to Euro (GBP/EUR) exchange rate forecast: Calibrating the Degree of Vulnerability in Both Currencies, GBP Upside Curtailed

An important factor in global currency markets is that the Euro and Pound Sterling exchange rates are both seen as vulnerable.

There are fears that the UK is heading for recession, but the Euro-Zone economy is exposed to high energy prices.

The ECB and Bank of England will both tighten monetary policy, but with expectations that both will face important limits on rate hikes given underlying frailty.

Fundamental vulnerability in both will tend to limit the scope for substantial Pound to Euro (GBP/EUR) exchange rate moves.

The GBPEUR exchange rate has drifted to below 1.1750 and well below 5-year highs near 1.22 in March.

The ECB move to tighten policy will tend to cap GBP/EUR support and, given UK vulnerability, most banks have cut their GBP/EUR forecasts

ECB Executes Sharp U-Turn

The ECB has consistently battled against low inflation since the 2008 global financial crash and maintained interest rates at extremely low levels.

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This stance during 2021 and the central bank is still buying bond through quantitative easing.

The overall stance has, however, shifted to a much more hawkish stance as inflation as increased sharply.

The latest Euro-zone inflation data recorded a headline rate of 8.1% for May from 7.4% the previous month. This was again above market expectations and a record high.

The underlying inflation rate also increased to a record high of 3.8% from 3.5%.

The bank signals have become much more hawkish during the second quarter as inflation has surged.

Nordea notes; “The ECB’s signals have constantly become more hawkish, pointing to a hike as early as the July meeting. This is also our baseline forecast. We see further 25bp moves in September and December this year and then quarterly in 2023, which would leave the deposit rate at 1.25% at the end of next year.

It adds; “Net asset purchases could be concluded already at the end of June, or by mid-July at the latest.”

According to DBS Bank; “ECB hawkish rhetoric is driving the cart. The next ECB policy meeting scheduled for 9 June is watching out for signs of a July policy lift-off. Given that inflation has nudged to 8.1% in May for the euro-zone, Klass Knot (a noted hawk, President of the Dutch central bank) has remarked a 50 bps rate hike is not off the table.”

It expects GBP/EUR exchange rate to weaken to 1.1500.

Euro-Zone Economy Vulnerable to Energy Supply Disruptions

The ECB has turned more hawkish, but there are also important reservations surrounding the Euro-Zone economic outlook, especially given the war in Ukraine.

The economy remains very sensitive to energy prices and there will be an important negative impact over the next few months.

The EU has reached agreement on an embargo of Russian oil imports with imports expected to decline 90% by the end of 2022.

According to Bank of America; “The market is already pricing the end of ECB QE in June, then 4 hikes this year and almost 4 more next year. We agree with the market for this year, but expect only 2 hikes next year.”

Deutsche Bank notes the potential that ECB tightening could re-ignite the Euro-area debt crisis in countries such as Italy. It notes; “Although lower yields provide relief, these countries will face similar interest costs as a share of GDP at lower yield levels than in 2011.

Goldman Sachs notes that any disruption to energy flows would cause major damage to the economy; “tail risks from the Russia/Ukraine war remain an important challenge. And while a full halt to Russia gas exports is not our expectation, any perceived change in the probability of that outcome can affect markets, given the severity of the possible impact on Euro Area growth.”

Rabobank expects ECB rate hikes will support the Euro, but also notes the economic vulnerability; “In anticipation of a July interest rate rise from the ECB, we see the potential for a gentle move towards EUR/GBP 0.86 into the summer, though upside potential in the currency pair is likely to be limited into year-end in view of recessionary risks faced by the Euro-zone.”

An End to Negative Euro Rates

Although there will be barriers to significant ECB tightening, the central bank expects that negative rates will come to an end this year.

CIBC expects this will be an important turning point. According to the bank; “When the ECB moved into negative territory back in Q2 2014, it forced many reserve holders to divest or unwind EUR holdings. The reduction coincided with the EUR losing more than a fifth of its value between the end of Q2 2014 and the end of Q1 2015.”

It adds; “Any move back towards positive rates would not necessarily result in an immediate rush of capital. However, any marginal uptick in reserve manager EUR appetite would provide a more substantive underpinning of the currency.”

UK Economy also in Trouble

The UK economy also faced major challenges over the next few months, especially given the surge in retail energy prices.

There will be a big hit to consumer spending which will undermine the wider economy.

HSBC commented; “The consumer outlook has taken a big turn for the worse, as the real income squeeze bites hard.

Credit Agricole maintains a very cautious stance towards the Pound; “Soaring energy costs, labour market shortages, global supply chain disruptions and persistent Brexit-related headwinds continue to plague the UK economic recovery and thus complicate the BoE’s ability to normalise in the face of uncomfortably high inflation.”

Socgen notes that the UK needs to attract capital inflows to finance the current account deficit. It adds; “the UK economy is slowing, and the market has already priced in a lot of the rate hikes already, so relative rate trends are less helpful than they were previously.”

Limits to BoE Tightening

The Bank of England has increased interest rates to 1.00% and expects that there will be further hikes over the next few months to combat inflation which has hit 9.0%..

The bank has, however, already expressed reservations over the economic outlook and fears over plunging the economy into recession are likely to limit monetary tightening.

HSBC adds; “This will make it very difficult for the Bank of England to deliver anything close to what is priced into the forward rates market.”

Unicredit added; “We still expect more GBP weakness over the medium term given a weakening UK economy and just one more BoE rate hike, probably in August.”

Goldman Sachs sees limited impact from Chancellor Sunak’s latest fiscal support package; “the macro impact is likely to be fairly small and arguably pales in comparison to the significant downside surprise in the UK services PMI, which was the biggest on record.”

It adds; “Taken together, we think it is unlikely to significantly alter the BoE’s measured approach, which we have argued is de facto a low real rate, weaker currency policy.”

Brexit Tensions Remain Unresolved

Brexit tensions have been simmering throughout the past year, but tensions have increased further given important stresses surrounding the Northern Ireland protocol.

There is important trade friction between Great Britain and Northern Ireland which has fuelled political discontent in Northern Ireland.

Sinn Fein became the largest party in the Assembly, but the Brexit dispute has prevented the formation of a government with the DUP insisting on changes to the protocol before engaging.

The UK government has promised to introduce legislation within the next few weeks which would give the government power to unilaterally suspend part of the protocol.

Negotiations will continue, but markets are wary over the threat of EU retaliation. Trade with the EU has also declined sharply which will hurt the UK economy.

MUFG noted; “We see it as quite likely now that this issue is going to escalate over the coming weeks and unilateral action by the UK could kick off a period of elevated uncertainty that will start to weigh on GBP performance.”

Commerzbank has also expressed concerns; “If the row about the Northern Ireland Protocol between the UK and the EU was to intensify and lead to a fully-blown trade war this might intensify the BoE’s and the financial market’s economic concerns. That means that sterling is likely to remain under depreciation pressure for now.”

Morgan Stanley sees Brexit as a negative factor for the Pound; “Brexit uncertainty is another factor that is likely to put further downward pressure on GBP, seeing as our idiosyncratic risk premium model is still suggesting little to no risk premium priced in at the moment.”

Prime Minister Johnson Still in Trouble

Prime Minister Johnson has so far managed to survive the “Partygate” affair, but his position has been weakened considerably and there is an important risk that he will face a confidence challenge by Conservative MPs in the short term.

CIBC summarises the bearish Sterling case; “The combination of extended and elevated price pressures set against downgraded growth forecasts, which are impacting rate assumptions, do not sit comfortably against a backdrop of enduring political uncertainty. Overall, there seems to be little to commend regarding Sterling.”

2022 -2023 Sterling-Euro Predictions: Table from Top FX Institutions