Pound Sterling Can Advance against the Euro Again this Week According to Crédit Agricole

- GBP/EUR fair value is higher than current levels
- Specialised model says buy Pound against Euro
- But Brexit, threat of -ve interest rates weigh on GBP
- Sunak's spending plans in focus mid-week

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Analysts at Crédit Agricole say that according to their currency valuation models the British Pound "remains significantly" undervalued relative to the Euro, and this could allow for another week of gains in the Pound-to-Euro exchange rate.

The investment bank's modelling has recently raised the fair value range for the exchange rate from 1.15 to 1.1640, which means Sterling's undervaluation relative to the Euro has widened within the course of the past week.

Based on the model's findings and resultant recommendations, Crédit Agricole are selling the Euro against the Pound, looking to book profit at 0.8589 in EUR/GBP, or 1.1643 in GBP/EUR.

At the time of writing EUR/GBP is at 0.9050 and GBP/EUR at 1.1050.

Crédit Agricole's "FAST FX model" - which makes recommendations based on shifts in fair value - is up 11.75% over the year with a hit rate (the ratio of winning to total trades) of 67%.

The Pound-Euro exchange rate rallied a percent last week, snapping a three week run of consecutive losses, with some observing that the pair had become oversold and was due a rebound. There is also a sense that while markets remain nervous of the outcome EU and UK trade talks, there is progress particularly as reports suggest the two sides have settled on a number of "landing zones" for the outstanding areas of disagreement.

Another round of talks between the EU and UK will take place in London this week and we therefore would look to either Thursday or Friday for any feedback on progress which could introduce some volatility into Sterling exchange rates.

Multi week view of GBP/EUR exchange rate

Above: Multi-week view of GBP/EUR

But ahead of this Pound Sterling will likely be subject to the market's reaction to the Government's summer spending review due on Wednesday, where further details on how the Government intends to shift tax and spending levers in the wake of the covid crisis will be released.

"The fiscal package to be announced by UK Chancellor of the Exchequer Rishi Sunak later this week will be a significant determinant of this trade’s success," says Valentin Marinov, Head of G10 Strategy at Crédit Agricole.

The shape and scale of the Government's fiscal response to the economic crisis caused by the covid-19 pandemic and subsequent lockdowns will ultimately determine how fast and robust the recovery is. Markets have tended to favour the currencies belonging to economies where initiatives have been bold as it suggests they will outperform the peers of economies where the response has been more lacklustre. 

The market does appear to have looked upon the Eurozone's response favourably, judging the recently proposed package put forward by the European Commission to be a credible signal of intent. The plan is worth around €750BN and the market judges this to be adequate enough to assist a strong economic recovery and the Euro has been bid higher as a result.

UK lagging the recovery

Above: Retail footfall for advanced economies (% from baseline). As the rest of the world bounces back into action the UK consumer remains cautious. Image courtesy of Berenberg Bank.

The flagship of the UK's response has undoubtedly been the massive jobs furlough scheme which costs about £14BN per month, which if continued at the same rate will total £69BN by October.

Bruna Skarica, an economist at Morgan Stanley says Sunak's fiscal statement will be the main event in the UK this week, but believes the focus of the event will be on preserving jobs leaving little room for major giveaways or tax rises which could underwhelm foreign exchange markets looking for a reason to bid Sterling higher.

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What we know is that renewed Brexit anxiety and ultra-loose monetary policy at the Bank of England are two factors behind the Pound's losses over recent weeks, but one potential ticket to support would be a sizeable boost to fiscal spending by the Government, that would give a kick to the economy and help it recover from the crisis.

With this in mind, all eyes were on Prime Minister Boris Johnson's 'new deal' announcement last Tuesday, where any surprises on additional Government spending had the potential to lift Sterling from its quagmire. In the event, it was announced that £5BN - or 0.2% of GDP - of spending on infrastructure projects would be brought forward into 2020.

The reaction by FX markets suggests markets were ultimately disappointed with analysts pointing out that only new announcements of additional spending would likely have had the ability to shift the dial on Sterling.

Ruth Gregory, Senior UK Economist at Capital Economics described the announcement as "fairly underwhelming and is unlikely to do much to help the hardest-hit parts of the economy over the coming months".

Sunak's address this week could also disappoint, with further spending announcements on infrastructure only likely to come in the autumn, "and an across-the-board VAT cut only if retail data disappoints over the summer," says Morgan Stanley's Skarica.

Morgan Stanley forecast an additional 3% of GDP of fiscal stimulus to be announced, which see a 15.6% of GDP deficit in FY2020/21, and 11.5% next.

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