Pound to Euro Week Ahead Forecast: Clutching for Support as Key UK Data Eyed

• GBP/EUR eroding major support at 1.1645 on charts
• But market pessimism may limit upside in short-term 
• UK data improvement key to further recovery for GBP
• Inflation, flash PMI surveys, retail sales data in focus

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The Pound to Euro exchange rate is eroding an important level of support on the charts and will face a battle to hold above the 1.16 handle this week unless a forthcoming flurry of UK economic data can dispel the market’s gloomy view on the outlook for Sterling.

Pound Sterling tumbled briefly below 1.15 against the single currency last week, marking its lowest level since April 2021, after the Office for National Statistics (ONS) announced a surprise economic contraction for April and the second consecutive fall in UK GDP.

However, last Wednesday’s curtailment of Russian gas flows to Germany and Italy helped place a floor under the Pound to Euro exchange rate before Thursday’s Bank of England (BoE) interest rate decision prompted a sharp but ultimately short-lived rally back above 1.17. 

"If we see greater evidence that the current high level of inflation is becoming embedded in pricing behaviour by firms, in wage-setting behaviour by firms and workers, then that will be the trigger for this more aggressive action," the BoE’s chief economist Huw Pill told Bloomberg News on Friday.

The BoE raised Bank Rate from 1% to 1.25% and gave guidance suggesting there may be some circumstances in which it could raise rates in larger than usual increments of 50 basis points later this year, prompting an uplift in market expectations for the months ahead.

Above: Pound to Euro rate at daily intervals with Fibonacci retracements of September 2020 recovery indicating short and medium-term areas of technical support for Sterling and shown alongside spread or gap between 02-year UK and German government bond yields. Click image for closer inspection. 

The BoE's statement that it “will be particularly alert to indications of more persistent inflationary pressures, and will if necessary act forcefully in response,” was interpreted by the market as meaning that it could be likely to lift Bank Rate in unusually large 50bp increments during the months ahead.

“We think the May and June inflation prints, to be published on 22 June and 20 July 2022 (ie, well ahead of the August meeting), will set the stage for the August decision. While a 25bp hike is our baseline, the MPC may hike by 50bp in August if it sees signs of more elevated and persistent inflation,” says Abbas Khan, an economist at Barclays.

Last week’s upward revision to market expectations benefited Sterling and helped lift the Pound to Euro rate briefly above 1.17 at the time but it also leaves more than is usually the case rested on the inflation figures and economic growth data emerging from the UK during the weeks and months ahead. (Set your own FX rate alert here).

This is just as the market consensus looks for the core rate of inflation to fall back on Wednesday and at a point when analyst expectations for the UK economy are becoming outright pessimistic, although data released during the week ahead could yet prompt a reappraisal on either of these fronts.

“We would expect Q2 and Q3 GDP quarterly GDP to be negative. Under such circumstances, we do not anticipate that the BoE will be able to meet implied rate expectation," says Jeremy Stretch, head of FX strategy at CIBC Capital Markets, who reiterated a bearish outlook for Sterling on Friday. 

Above: Pound to Euro rate shown at daily intervals alongside spread or gap between 02-year UK and German government bond yields and S&P 500 stock index. Click image for closer inspection. 

The market consensus suggests that inflation likely rose from 9% to 9.1% in May but that the more important rate of core inflation likely fell from 6.2% to 6%, which would do little to help Sterling this week.

“We think the headline rate of CPI inflation held steady at 9.0% in May, thus falling short of the 9.2% rate forecast by the MPC in last month’s Monetary Policy Report,” says Samuel Tombs, chief UK economist at Pantheon Macroeconomics.

“Importantly, the downside surprise looks set to originate from core inflation, which we think fell to 5.9%, from 6.2% in April. That would reduce the chances of the MPC acting “forcefully” to bring down inflation over the medium term,” Tombs also warned on Monday.

The Pound would be likely to benefit, however, from any surprise increase in core inflation because the market would view it as a broadening out of price pressures that could have implications for the BoE interest rate outlook.

But while Wednesday's inflation data is important, Thursday's S&P Global Flash PMI surveys of the services and manufacturing sectors and Friday’s retail sales report for May are, arguably, at least as important for the Pound given the widespread pessimism about the outlook for the UK economy of late. 

Above: Pound to Euro rate shown at weekly intervals with selected moving-averages and Fibonacci retracements of September 2020 recovery indicating short and medium-term areas of technical support for Sterling.

“The flash PMIs for June will suggest that economic growth has slowed to a crawl, but that this weakness isn’t filtering into an easing of price pressures,” says Ruth Gregory, a senior economist at Capital Economics, who also looks for retail sales to fall on Friday.

“A 2.0% m/m fall in retail sales volumes in May would more than reverse the 1.4% m/m rise in April, be the third decline in four months and suggest that the reduction in real incomes are starting to bite,” Gregory also said on Friday.

With economists increasingly pessimistic about the economic outlook many also now doubt the BoE will be able to meet expectations for interest rates, and the danger is that this week's economic data merely feeds that pessimism.

This would potentially leave the Pound to Euro exchange rate at risk of another fall back below the 1.16 handle in the days ahead.