Pound-Euro Back at 1.16 on Significant Interest Rate Shifts

Above: Christine Lagarde. Image by Dominique HOMMEL. © European Union 2019 - Source: EP

A lift in UK interest rate expectations relative to those of the Eurozone bolsters pound sterling.

Pound-euro crossed 1.16 on Thursday with investors responding to the European Central Bank and Bank of England updates. The takeaway is that both are facing an uncomfortable few weeks ahead as the Middle East war pushes energy inflation higher.

However, the workloads will differ: the Bank of England has potentially more heavy lifting on rates than its cross-channel peer.

The Bank left rates on hold and the Monetary Policy Committee voted 9-0 to do so. It also raised its inflation forecasts quite significantly, with 3.0% now seen as being the average for the second quarter of this year.

The European Central Bank also said it's alert to the impacts of the Middle East war, but the Eurozone enters the crisis from a much more helpful position: Eurozone inflation was already at target near 2.0%, whereas the UK was well above that golden level.

"In the ECB’s baseline scenario, the effects remain manageable," says Felix Schmidt, an economist at Berenberg. "It is a good position to navigate the uncertainty."

Money markets price a hike from the ECB this year as the central bank is expected to act in order to ensure inflation doesn't get out of hand.

Three weeks ago, money markets saw the ECB maybe cutting rates again before year-end, although this wasn't a conviction bet as it was clear that the ECB thought it was in its "good place".

Now contrast this to the UK, where money markets saw two cuts for this year at the start of the month. This means the market has swung from -50 to +50 in just three weeks!

That's a phenomenal repricing that's sent gilts lower, gilt yields higher and delivered pound sterling gains. "Higher yields have supported a stronger GBP, but the currency’s gains have been muted relative to the scale of the adjustment in rates," says Lee Hardman, FX strategist at MUFG Bank Ltd.

For GBP/EUR, eyes are on a potential rise into the 1.16s. First is the 1.16 level itself which will prove a tough ceiling for the exchange rate to crack, as it has rebuffed advances on numerous occasions since last year.

If the pair can close the day above here, we'd take it as a sign that potential follow-on gains are coming.

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