How Euro Strength is Driving the Rally in Pound / Dollar Exchange Rate

Triangulation of cross rates could see another bout of broad Euro strength lifting the GBP/USD rate, regardless of what happens in the UK. 

The Pound-to-Dollar exchange rate rate could be a natural beneficiary of a strong Euro over the coming months, according to strategists, who see the common currency’s surge lifting the Pound against the Dollar due to the market’s mechanism for calculating cross-rates such as the Pound-to-Euro.

The Pound has been experiencing a sustained rally against the US Dollar of late while simultaneously threatening fresh multi-year lows against the Euro.

Granted, broad-based US Dollar weakness and broad-based Euro strength are significant features of currency markets at present, but there are additional subtle factors to consider when observing Sterling.

The GBP/EUR rate is determined in the interbank market using a process known as triangulation, which divides the bids and offers of the EUR/USD pair over the offers and bids of the GBP/USD pair in order to get the EUR/GBP pair - which is then inverted to get GBP/EUR.

Therefore, in order for the Euro to rise meaningfully against both the Pound and the Dollar at the same time, the GBP/USD rate must also naturally rise.

So the strengthening Euro in effect offers support to Sterling against the Dollar.

“Cable remains very much an ‘ugly contest’ between the GBP and USD,” says TD Securities strategist James Rossiter in a note Monday. “If we do see a sharper rise in cable than we currently expect, it may come as a consequence of the ‘triangulation’ between EUR/USD and EUR/GBP rather than as a result of Sterling’s own individual merits.”

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Pound Could Continue Rising Against the Dollar, But not the Euro

But Sterling is not doing too badly, in fact for now it appears to be quite immune to negative headlines.

“We believe that both a softer UK economic outlook and domestic political risks are now adequately priced in and only an escalation in either would result in further idiosyncratic GBP downside,” says Chris Turner, head of foreign exchange strategy at ING Group.

The Euro's rally following the ECB’s September meeting appears to have hit the pause button but while Mario Draghi made a verbal attempt to talk the Euro lower, some strategists do not expect it to have a lasting effect and see continued resilience from the Euro against the Pound.

“We expect EUR/GBP to extend its uptrend amid enduring EUR strength. As a partial offset, cable may remain somewhat firm on the back of broad USD weakness, but for now we would downplay the chances for a rapid acceleration of gains out of the current trend channel,” says Rossiter.

Rossiter does however caution of an unexpected 'hawkish' surprise being delivered by the Bank of England on Thursday, which might result in a major repricing in the value of the Pound-to-Euro exchange rate.

The Bank's interest rate decision and policy statement could take much guidance from Tuesday’s inflation figures and Wednesday's wage data, so traders will be watching these numbers with interest.

The Office for National Statistics will release the latest volley of inflation data on Tuesday at 09:30 London time.

Headline consumer price inflation is expected to rise 20 basis points to 2.8% for the month of August, according to the consensus forecast of economists, while the BoE expects inflation to rise to 2.7%.

A substantial overshoot of these forecasts could mean there is a danger the BoE adopts a more hawkish tone in its policy statement, which would have far reaching implications for Sterling foreign exchange markets.