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Higher oil prices lift UK inflation expectations and rate hike bets, handing the pound support against the euro.
The British pound starts the week on the front foot, with a renewed rise in oil prices once again feeding through to sterling via UK bond yields.
The pound-to-euro exchange rate is 0.25% higher on the day at 1.1657, and the pound-to-dollar rate is up 0.1% at 1.3258.
Brent crude snaps recent falls and trades above $107 a barrel after President Donald Trump rejected an Iranian proposal to reopen the Strait of Hormuz within seven days.
"They made a proposal but I rejected it," Trump told reporters.
Tehran says it will not soften its conditions, which include the lifting of the US naval blockade and the release of frozen assets, although Trump says he expects talks to resume this week.
"The Brent crude continuous contract is back above $100 per barrel. This is also putting upward pressure on sovereign bond yields," says Kathleen Brooks, Research Director at XTB.
Oil Moves into GBP/EUR through Yields
Monday's move repeats a pattern that has held since the conflict began in February: the pound-to-euro rate rises with oil and falls with it.
Two channels drive the relationship:
1) Markets judge the Eurozone, with its large manufacturing base, as more exposed to an energy shock than the services-weighted UK economy.
2) Higher oil lifts UK inflation expectations, which raises the odds of a Bank of England rate hike and pushes up the gilt yields that attract capital into sterling.
Above: UK ten-year bond yields rise as oil prices rise. That yield pick-up has tended to bolster the pound, all else equal.
The second channel has strengthened since Governor Andrew Bailey said on Friday it will get harder to keep rates on hold the longer energy prices stay high.
Bailey said policymakers cannot wait for full evidence of second-round inflation effects "because it's going to be too late."
UK money markets attach an 80% probability to a November rate hike, with close to three further quarterly hikes priced beyond that, according to KBC.
"EUR/GBP grinded lower with the recently taken out 0.86 already under attack again," says a daily note from KBC, the Belgian bank. That 0.86 level in euro-to-pound terms equates to 1.1628 in the pound-to-euro rate, which is where the pair closed on Friday.
Daniella Arcadipane, Senior Currency Specialist at Indigo
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Talk to a specialistDiesel Hits a Record
The pass-through to UK households is already visible at the pump, with the average litre of diesel reaching an all-time high of 199.18p, according to the RAC.
Diesel is up 56.8p a litre since the start of the war, and RAC Head of Policy Simon Williams expects the cost to be passed on to consumers through goods carried by lorries and vans.
"There will be rising concerns about the economic impact, and how the BOE will react," says Brooks.
Neil Parker, Head of Economics and Market Strategy at Moneycorp, flags a gathering storm for the UK as fuel prices jump again. "Upward pressure on energy prices is likely to persist," he says.
That persistence is what keeps the Bank of England under pressure to act, and it keeps sterling's yield support in place.
Above: GBP/EUR showing Friday and Monday trade.
The Euro's Counterweight
The same oil shock raises the stakes for the European Central Bank.
KBC notes that the combined oil and gas price curve sits on the ECB's adverse scenario, laid out by Chief Economist Philip Lane last week.
"In such case, money markets pricing in a 40% probability of a back-to-back October hike may be an underestimation," says KBC.
A repricing of ECB hike bets would give the euro its own yield support and cap the pound-to-euro rate's gains.
GBP Upside Limited Amidst Fiscal Risks, Eyes on Labour Party Conference
Pound sterling upside is meanwhile expected to be strictly limited in nature thanks to an increasingly uncertain domestic news flow concerning the fiscal outlook, and we wouldn't be surprised if periods of strength this week are met with increased selling interest.
That's a reflection of the fiscal risks that lurk on the horizon: the Labour Party conference is underway, and there's been a blitz of spending commitments, which are then counteracted by a commitment to respect the fiscal rules.
This leaves markets navigating a seemingly contradictory policy outlook, for instance: a pledge to make a free universal care service is countered by rumours of killing off the pensions triple lock. Chancellor John Healey used his speech to argue for restraint on benefit payments.
So, there's a lot of give and take, and we think the uncertainty ahead of the Budget, when the cards must be laid out, will keep traders shy of the pound.
This week's key events for GBP/EUR:
• Wednesday: UK final Q2 GDP and German preliminary inflation
• Thursday: Bank of England Governor Bailey speaks
• Friday: Eurozone flash inflation for September and US non-farm payrolls
Oil remains the dominant input, and the week's talks between Washington and Tehran are the swing factor.
"Any meaningful progress could drive crude lower, while another breakdown in talks or tighter conditions across Hormuz and Bab el-Mandeb would strengthen the case for renewed gains," says Mahmoud Mashal, Senior Market Analyst at VT Markets.
A breakdown keeps oil and gilt yields elevated and puts the 1.1689 level that capped the pound-to-euro rate earlier this month back in play, while progress in the talks would pull the pair towards the 1.1615 floor set after the Bank of England's September decision.
Daniella Arcadipane, Senior Currency Specialist at Indigo
Moving a life-changing sum abroad? You won’t be doing it alone.
One specialist explains every step in plain English and stays with it until the money lands. FCA authorised, FRN 594433.
Talk to a specialist
