Pound's Slide Against Euro Still A Conviction Call At Nomura

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Investment bank says pound's slide intact, but others warn of resilience as UK inflation will remain above target.

Analysts at Nomura reiterate their 'long' EUR/GBP trade following this week's release of UK employment and inflation data.

The call for further pound sterling weakness follows a set of soft UK data readings that mean UK interest rates will steadily fall towards those of the Eurozone in the coming months. "There is still scope for further rate convergence between EUR and GBP," says Dominic Bunning, strategist at Nomura.

The pound to euro exchange rate is down half a per cent this week, with most of those declines following Tuesday's news that the UK unemployment rate had risen to 5.2% in December, a five-year high.

"The UK unemployment rate has risen much further than most of its developed market peers," says Bunning.

The Bank of England will lower interest rates again in March and money market pricing shows investors see another reduction by mid-year, a move that will offer the economy some support. But the European Central Bank (ECB) has ended its rate cutting cycle, meaning UK interest rates will fall closer to those in the Eurozone.

That convergence will naturally weigh on pound sterling.

Nomura's trade to sell the pound against the euro was raised to a 5/5 conviction in January, and Wednesday's strategy update from the bank reaffirms the stance, targeting a move in EUR/GBP to 0.8950, which gives a GBP/EUR target at 1.1170.

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The odds of an interest rate reduction in March rose to a near certainty after headline CPI inflation fell to 3.0% in January, according to an ONS report released Wednesday.

Markets see another rate cut after that - taking Bank Rate to a resting point at 3.25% - before year-end, but analysts at Peel Hunt think inflation dynamics mean a further reduction is possible, meaning markets will have to adjust expectations further, which would weigh on sterling.

Kallum Pickering, economist at Peel Hunt, says this week's data confirms a clear downward trend in UK headline inflation towards the BoE's 2% target.

"Looking at annualised data, which gives a better measure of current price pressures, the BoE is now undershooting its target. Given known lags with monetary policy, the clear risk now is that the bank has fallen behind the curve and will need to play catch up - skewing risks towards more than the two cuts money markets see for this year," he explains.

Image courtesy of Peel Hunt's Kallum Pickering.

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However, some analysts think there's a limit to the extent the Bank of England repricing can exert pressure on the pound.

"Our economist sees a terminal of 3.25% by June, whereas markets price that by year-end. An additional cut could be brought forward into H1, but it will be hard for BoE to ease much more than that with neutral around 3%... This puts a floor under BoE driven GBP weakness in our view," says a new foreign exchange research note from JP Morgan.

Dig beneath the headlines of Wednesday's inflation data and there are warning signs that the Bank of England will continue to struggle with stubborn inflation dynamics.

"It was the services sector where inflation can be stickier that continued to post above-expectations price increases," says Lloyds Bank in a note covering the inflation release. Services inflation read at 4.4%, which is well above a level consistent with a sustained fall in inflation to the 2.0% target.

Above: Services inflation must fall further if CPI is to fall to 2.0% on a sustainable basis.

"Business surveys suggest that underlying cost pressures remain sticky, and medium-term inflation expectations are still too high for comfort," says the IEA in their response to Wednesday's data.

Oxford Economics raised its UK inflation forecasts following the figures, "partly due to us factoring in new regulatory price announcements over the past month, some of which have been slightly higher than anticipated."

"Our forecast means we now see CPI inflation averaging 2.6% this year and next, up from 2.3% and 2.5% previously," says Oxford Economics.

Such stubborn inflation would prevent the Bank of England from cutting on more than two occasions this year, limiting the extent of GBP weakness.

A new research note from Handelsbanken says UK inflation will rise again by the year-end, with persistence re-emerging as a challenge for policymakers, meaning the Bank of England is likely to keep policy relatively tight compared with several peers.

"This keeps front-end rate differentials elevated and provides cyclical support for GBP through the carry channel," says the note.

To be sure, a number of headwinds blow against the pound, but a Bank of England hamstrung by inflation could well put a limit below the degree of weakness the currency is exposed to.

🎯 GBP/EUR year-ahead forecast: Consensus targets from our survey of over 30 investment bank projections. 📩 Request your copy.