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Summary
- Since last May, EUR/GBP has traded in a ~0.8500/~0.8800 range.
- This week, EUR/GBP printed its lowest levels since September, primarily catalysed by a hawkish pricing tilt in BoE expectations.
- We think this hawkish BoE pricing has gone too far and that ECB easing will be less aggressive than the market currently prices.
Market Implications
- We see value in fading EUR/GBP’s decline in recent weeks.
- We like scaling into a long EUR/GBP position into support at ~0.8500, with a view to the pair trading back between 0.8750 and 0.8800, last seen in November.
EUR/GBP Has Cheapened to Attractive Levels
Since rallying above 0.8700 briefly in late December, EUR/GBP has fallen about 2%, with roughly a third of that move in the past week or so.
The pair now trades just above 0.8550, hovering above the solid support near 0.8500, the lows seen in July and August.
As such, ahead of this solid support zone, we think there is value in fading the recent decline in EUR/GBP.
Hawkish BoE Repricing Has Been Aggressive …
We think the latest fall in EUR/GBP, which has accelerated this week and taken the pair to its weakest level since early September, has been driven mostly by a hawkish repricing in BoE rate expectations.
Using the 3-month, December 2024 Sonia futures contract as a proxy for BoE rate expectations, prices have fallen (and implied yields have risen) the most since the sharp move seen in the late June/early July period last year.
… And This Hawkish Move Has Gone Too Far
We have argued that this hawkish shift in BoE expectations has seen UK short-end yields rise too much and have been fading the lurch higher.
The economic argument behind this view is as follows:
- UK core inflation continues to normalise. Despite headline, core and services inflation all ticking up in December (after November’s sharp decline), they continue to undershoot BoE forecasts.
- The UK consumer is under a lot of pressure, hit by rent and mortgage rate rises (rent inflation being just a passthrough of monetary policy right now).
- The UK labour market is loosening faster than the BoE had expected in terms of wage growth (to be confirmed by the UK’s Office for National Statistics corrections). If the recent trajectory in private pay is maintained, wages will continue to undershoot the BoE’s most recent Monetary Policy Report forecasts and drop sharply in H1.
- Fiscal policy remains relatively tight, so it does not offset the monetary tightening.
ECB Market Pricing Is Still Too Dovish
Contrasting the too-hawkish BoE market pricing identified above, we also think ECB market pricing is still too dovish and are positioned as such.
The key reason to expect the ECB to hold off on near-term cuts is because, by waiting, the central bank will be able to see the latest prints of the most relevant economic inputs (final Q1 inflation and Q1 wage negotiation data).
Added to this, before the current blackout period began, several ECB speakers (including Lagarde) pushed back on near-term cuts (i.e., before June).
The market currently prices the first ECB rate cut in June. We agree with this timing. Nonetheless, we think the first rate cut will be 25bps, unlike market expectation of over 40bps.
As such, fading this overly dovish pricing is still attractive.
Fading EUR/GBP Weakness = Fading BoE and ECB Market Pricing
Overly hawkish BoE market pricing, combined with too-dovish ECB market pricing, means that the recent decline in EUR/GBP is worth fading.
With solid support between the current level and the 2023 low near 0.8500, we like scaling into a long position, targeting the November high above 0.8750.
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Richard Jones writes about FX and rates markets for Macro Hive. He has traded and invested in interest rate and FX market portfolios spanning three decades, both on the buy-side and sell-side.
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