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Pound is an Attractive "Buying Opportunity" vs Euro say BMO Capital Markets

-Pound-to-Euro rate offers attractive "buying opportunity" at 1.13.

-Robust UK labour market to support expectations of BoE rate hike. 

-Italian politics should constrain Euro's ability to push back against GBP.

© Savo Ilic, Adobe Stock

The Pound-to-Euro rate offers an attractive buying opportunity to traders at current levels, according to strategists at BMO Capital Markets, who told clients Tuesday that they should buy any dips in the exchange rate Wednesday.

This is because UK economy is likely holding up better than some recent data points have suggested and there is still scope for economic data to improve throughout the rest of 2018. As a result, investors may have become too pessimistic about the outlook for Bank of England to raise interest rates in 2018.

"The labour market data stand in sharp contrast to some of the softer-than-expected prints from some of the other areas of the economy. This paints a mixed picture for the MPC, but given the importance of labour market and wage dynamics in the policy setting process, it’s tough to argue that what is currently priced into the OIS curve is excessive," says Stephen Gallo, head of G10 FX strategy at BMO Capital Markets, a division of Bank of Montreal.

Gallo argues that strong jobs numbers mean current market expectations for one interest rate rise before year end are not unreasonable. After all the UK unemployment remained at 4.2% in the three months to the end of April, its joint lowest level since 1975, and the number of welfare claimants posted a surprise 7,700 fall.

There were 146,000 more people in work during the three months to the end of April than there were in the period leading up to the end of January, and 440,000 more in work when the quarter to the end of April 2018 is compared with the same period one year ago, suggesting the UK labour market remains in robust condition.

1.42 million people classed as unemployed during the period, 38,000 fewer than in the three months to the end of January and 115,000 fewer than there were one year ago. Meanwhile, the youth unemployment rate was 11.9% during the recent period, down from 12.5% one year ago and not a long way off from the all-time low of 11.6% seen in May 2001.

This is just the latest set of figures to reflect a robust UK labour market, which is at its strongest for close to four decades, but the data comes hard on the heels of a steep fall in UK inflation and an economic slowdown in the first-quarter.

Falling inflation and slower growth have seen markets go from betting the BoE raises interest rates twice in 2018, as recently as April, to being outright sceptical of whether it will even manage one hike before December.

"The strength of the UK’s labour market and a Brexit process that refuses to spiral out of control justify at least one hike staying the curve by year-end. Political risk in the Eurozone should also dampen the EUR’s ability to rally. In the event of a weaker-than-expected UK CPI print, I would look to fade the rally in EURGBP," Gallo adds, referring to the inverse of the Pound-to-Euro rate.

Pricing in interest rate derivatives markets implies a November 08 UK Bank Rate of 0.66%, which is 16 basis points above the current 0.50% rate and suggests around a 64% chance the BoE will raise its interest rate at the November meeting. Any change for the better in this implied probability can be expected to support Sterling during the months ahead.

Meanwhile, the Euro could be hampered by lingering uncertainty over the stability of the Eurozone now that Italy has an anti-establishment government whose commitment to the single currency is questionable.

Markets currently anticipate that the European Central Bank will soon end its quantitative easing programme, delivering a boost to the Euro, but this will also raise the single currency's sensitivity to adverse news from Italy seeing as the central bank will no longer be keeping Italian government bond yields compressed as manageable levels.

"In the event of a hawkish ECB on Thursday, I would also look to fade the rally in EURGBP. All in all, this should translate into a EURGBP selling opportunity in the vicinity of 0.8850," Gallo concludes, referring to a level of EUR/GBP that corresponds to a Pound-to-Euro rate of 1.1299.

The Pound-to-Euro exchange rate was quoted 0.04% lower at 1.1359 during early trading Wednesday after having risen by 60 points from the 1.13 level on Tuesday. It is now up by 1.13% for the 2018 year to date.

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