Pound to Euro Rate Set for sub-1.10: Citi Strategists

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The British Pound could be in for a pronounced decline against the Euro say foreign exchange specialists at one of the world's largest foreign exchange prime dealers.

Strategists at Citibank have this week recommended clients buy the Euro against the Pound as they target a move below 1.10 in the Pound-Euro exchange rate.

The trade was given a timely boost midweek after UK inflation data came in cooler than the market was expecting, prompting a rally in UK bond yields and a wider selloff in the Pound.

UK government bonds - known as gilts - were in demand relative to peers in the U.S. and Eurozone after UK CPI inflation fell to 10.1% year-on-year for January, which was shy of the consensus expectation for 10.3%.

Investors are more inclined to buy bonds when they perceive more favourable inflationary conditions ahead, as this lowers the risk of their value being eroded.

Core inflation dropped to 5.8%, which was well below the 6.2% estimate, leading to falls in the Pound in excess of 1.0% against the Dollar and 0.60% against the Euro.

"While we don't want to read too much into one print, the peak appears to be in," says Rui Ding, an analyst at Citi.

Demand for gilts in turn pushed their yield lower relative to elsewhere, which has a mechanical drag on the value of the Pound as the textbook says capital will flow to it can yield greater returns.

While UK two-year yields declined 2.50% on the same day inflation numbers were released, the German equivalent actually rose a third of a percent.

Recall, last week Pound Sterling Live reported that the recent recovery in the GBP/EUR exchange rate was driven by the faster appreciation in UK bond yields relative to German counterparts.

The dynamic is intact and has led to a reversal in yields and GBP/EUR in the wake of the UK's inflation numbers.

Above: The difference between the UK's two-year bond yield and that of Germany has shrunk again (see the most recent red candle in top chart). This corresponds with the drawdown in GBP/EUR (bottom chart).

The Bank of England will welcome signs that core inflation is finally declining, meaning money markets are pricing in lower interest rates in the future.

This in turn feeds back into why bond yields have fallen faster in the UK than elsewhere, which acts as a drag on the Pound.

"GBP is understandably one of the worst performers on the day," says Ding.

Citi's economists still expect 25bp to be delivered at the next Bank of England meeting owing to the robust wage dynamics of the UK, but they caution the likelihood of a pause in May is increasing.

Strategists at Citi recommend traders buy the Euro against the Pound, targetting an eventual move to 0.92 (1.08 in Pound to Euro terms).

Foreign exchange strategists at RBC Capital Markets also recommended a EUR/GBP buy at the start of this week as they anticipated a softer-than-expected CPI inflation reading.

Their prediction has proven correct and the expected rally in the Euro relative to Sterling has followed.

They also observed the technical conditions were also in place for a EUR/GBP rise:

"EUR/GBP is near the bottom of the ascending channel that has held since late last year s o we go long EUR/GBP with a stop just below the rising trendline," said Elsa Lignos, Global Head of FX Strategy ahead of this week's events.

The trade targets a move to 0.9030 (1.1075 in Pound-Euro terms).