Pound to Euro Week Ahead Forecast: Topping and Potentially Dropping

• GBP/EUR rally meets resistance at 1.1675 on charts
• Recovery in final throes with risk of setback now high 
• Short-term 'fair value' likely in 1.1516 to 1.1791 range
• But 'fair value' trend on a downward sloping trajectory 
• As UK & EU core inflation appears set for divergence 

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The Pound to Euro exchange rate reached new highs for the year last week but technical and fundamental headwinds could now be set to constrain its recovery, potentially leaving Sterling at risk of topping out in the days ahead.

Sterling extended a five-month recovery as far as 1.1675 against the Euro last week when climbing for four out of five trading days in what may have been a further response to the prior week's sharp uplift in market-implied expectations for the Bank of England (BoE) Bank Rate.

The implied peak for Bank Rate rose from just more than 4.75% to almost 5.5% the prior week after Office for National Statistics suggested homegrown inflation strengthened further in the UK during April when it had been widely expected to ease, leaving the BoE in a bind. 

"As a result, our economists recently raised their terminal Bank Rate forecast to 5.25% in September (vs. 5% in August), implying another three 25bp hikes ahead," says Michael Cahill, a G10 FX strategist at Goldman Sachs.

"Given EUR/GBP is now trading near our initial target of 0.86, we are closing our short EUR/GBP trade recommendation for a potential profit of roughly 1.5%, but we will be looking for opportunities to reengage," Cahill and colleagues write in a Friday research briefing. 

Above: Pound to Euro exchange rate shown at daily intervals with Fibonacci retracements of February 2022 downtrend indicating possible areas of technical resistance for Sterling while selected moving averages denote possible support. 

Last week's chart breakout and rapid advance led some in and around the market to anticipate a continuation of the rally in what is set to be a quiet week for UK and European economic newsflow, although there are also reasons why further gains could now be more difficult to come by.

First is the 61.8% Fibonacci retracement of the February 2022 downtrend sitting immediately overhead at 1.1675 on the charts, which might take time to erode in light of how the 50% retracement of the same trend succeeded in frustrating the rally in Sterling through much of May. 

Another is valuation and the corrosive effect that recent inflation developments in the UK and Europe are having on the fair or fundamental value of GBP/EUR.

"If UK inflation remains stubbornly high on a relative basis, I see more downside than upside GBP potential — on the view that currencies will be rewarded when their respective central banks have more success in bringing inflation down," says Stephen Gallo, a global FX strategist at BMO Capital Markets. 

"A failure to do so carries too many economic, fiscal, and BoP negatives. In view of the recent weakness, EURGBP stands out as a value proposition (i.e. gradually building exposure for a move back to 0.90 [GBP/EUR: 1.1111)," Gallo writes in a Friday research briefing.

Above: Pound to Euro exchange rate shown at weekly intervals with Fibonacci retracements of February 2022 downtrend indicating possible areas of technical resistance for Sterling while selected moving averages denote possible support and/or resistance.

Inflation is corrosive of the theoretical value of currencies wherever not compensated for by interest rates and with Eurostat saying last Thursday that both of Europe's main inflation rates continued to fall in April, GBP/EUR's fair or fundamental value is at risk of impairment.

"With core inflation dynamics in the UK starting to stand out versus other major economies, sterling ought to remain very sensitive to any negative repricing in UK real yields," says Shreyas Gopal, an FX strategist at Deutsche Bank.

"We think the risk-reward profile is skewed to the downside in the pound," he adds in a Friday research briefing.

The author estimates a 'fair value' range for each currency using inflation, inflation differentials and interest rate differentials; These are used to discount the Dollar value of currencies from the point at which inflation first exceeded their respective central bank targets.

This exercise suggests the Pound to Euro rate is currently fairly valued somewhere between 1.1516 and 1.1791.

Above: Quantitative model estimates of ranges for selected pairs this week. Source Pound Sterling Live. 

Most G10 currencies currently trade below the lower end of their estimated fair value ranges with the only exceptions being the Euro and Swiss Franc, which might be a symptom of the degree to which the market still perceives inflation risk as being to the upside. 

But the relatively slower pace at which UK inflation is declining compared with Europe leaves the trajectory of GBP/EUR's fair value downward sloping.

This would remain the case without offsetting increases in the BoE Bank Rate and could potentially constrain the extent to which Sterling is able to rise further in the short-term.

"A further hike to 4.75% on June 22, from 4.50%, now looks very likely, and we think a further 25bp hike in August to 5.00% is a solid bet too," says Gabriella Dickens, an economist at Pantheon Macroeconomics.

"But we doubt the MPC will be quite as proactive as markets currently expect. CPI inflation still looks set to fall quite quickly over the coming months," she says of , of the outlook for BoE interest rate policy.