Why the Pound to Euro Exchange Rate Should Actually be at 1.37

The GBP to EUR is left looking soft heading into the weekend, but the pound should still manage to record its third consecutive weekly advance against the euro. Will next week make it a fourth?

pound to euro 1

  • Still further upside to be had for GBP/EUR when rate differentials are accounted for.
  • Next week the tone will be set by UK PMI data
  • ECB and inflation form focus of the euro's week ahead.

Pound sterling has pulled back from peaks in most major pairs after several recent referenda showed the Remain vote is losing its lead.

While a weekly advance should be a certainty heading into the weekend, the pound has certainly been looking softer over the past 48 hours as it corrects from the overbought conditions imposed by the break-neck speed of the recent recovery.

The caution heading into the weekend is justified in our view as the recent optimism expressed over Remains supposed advantage is looking misplaced.

"We have now seen four polls released this week, with only one showing a Remain win, two a dead-heat, and one showing a Leave majority," says Ned Rumpeltin at TD Securities.

With the recent deterioration in polls and a month still to go before the event, we believe the market’s recent surge in optimism looks premature and remains vulnerable to an unwind.

What happens between now and polling day is anyone's guess. One thing we are sure of though is that the gap between the GBP/EUR and its true-value rate will remain wide. i.e markets will continue to discount the EU vote into the exchange rate.

Should Remain win, then the gap should finally close, resulting in further GBP/EUR gains.

A study of the EUR/GBP exchange rate and the Eurozone/UK interest rate differences confirms the existence of the gap:

EUR to GBP and interest rate differentials

Tellingingly the study, courtesy of DNB Markets, suggests that were the pound to be at true-value it would be at about 0.7259 today.

In GBP/EUR terms this is 1.3776.

Those hoping for a stronger pound will have to be patient though - the difference between fair-value and the exchange rate will almost certainly persist into the weeks following the vote.

Sterling Near 2016 Highs vs US Dollar

Sterling remains close to 2016 highs against the US dollar as markets cancel out the prospect of a UK exit.

"GBPUSD levels below $1.50 represent a seldom seen ‘buying zone’ over the better part of the last several decades. If Britain votes to stay in the bloc on June 23, GBPUSD would have a better chance of reclaiming levels above $1.50, and remaining there for a time," says analyst Joe Manimbo at Western Union.

There is also growing concern that sterling could be prone to disappointment were polls to turn back in favour of the Leave camp.

The YouGov poll for the Times on Wednesday showed support to remain in the EU fell to 41% from 44% previously whilst support to leave rose a percentage point to 41%. The number of Undecided’s was still quite a high 13%, 4% would not vote.

A recent ICM poll also showed a fall in the Remain vote, which showed the two camps neck-and-neck.

"We think this rebound in sentiment toward cable may be reaching its peak, however. With a full month to go before the vote, we see notable risks that opinion could revert back to a more even keel," says Ned Rumpeltin at TD Securities.

The Outlook for GBP/EUR and GBP/USD

From a technical perspective the GBP/EUR it is moving up towards the target calculated from an inverse head and shoulders which has formed at the lows.

Inverse head and shoulders (H&Ss) form after an extended down-trend. They are a sign that the trend is coming to an end, and that there is about to be a bullish reversal.

They are composed of three consecutive troughs, the middle of which (the head) being slightly lower than the other two (the shoulders).

GBPEURMay26

The neckline is the line which connects the top of the three troughs – literally at the level of the ‘neck’ on the H&S. It needs to be breached to confirm a valid break higher. This is also the sign the trend has changed.

A break to the upside is normally expected to extend as far as 100% of the height of the head, extrapolated up from the neckline, although a safe minimum expectation is for it to reach 61.8% of the height of the head extrapolated up.

The inverse head and shoulders on GBP/EUR has produced a minimum target at 1.3285 (61.8% of the height of the head). The pair has already moved above the 1.3090 confirmation level, reaching highs of 1.3221 on Wednesday, but it is now pulling back again, having retraced to the current 1.3150 level.

The pair should resume its up-trend, however, eventually and move back up to the 1.3265 base expectation.

The GBP/USD pair has risen strongly during this week from lows of 1.4442 to highs at 1.4739, it is currently just off those highs trading at 1.4712.

Whilst previously we forecast that a break above the 1.4665 highs would lead to an extension higher to the 200-day moving average (MA) at 1.4798, the MA has now moved lower however, and in so doing has lowered the target to 1.4771.

 GBPUSDMay26

Data: GDP Numbers Fail to Stimulate Fresh Upside

The pound may also have been hit after second estimate GDP growth data was released, and showed a slight fall in annualized growth in Q1 2016, dropping a basis point to 2.0% from the 2.1% preliminaries. Quarter on quarter growth, however, remained unchanged from preliminary estimates of 0.4%.

The loss of growth was seen as reflective of uncertainty around the UK’s place in the EU, which has detracted from direct foreign investment into the UK as foreign investors waited to see what happened before investing their capital.

The Pound Next Week

The pound has soared as markets price the Remain vote winning the EU referendum in June. The big question is how long this dynamic can last. We hear that against the euro this dynamic could continue, while against the dollar there is no room left.

And how long until the GBP starts responding to data once more? Over the coming week we will find out as the much-watched Purchasing Managers Index, compiled by Markit, is released.

Events to Watch

  • June 1st: Manufacturing PMI. Market forecast: 49.9
  • June 2nd: Construction PMI. Market forecast: 51.8
  • June 3rd: Services PMI

Market forecast: 52.6

“We saw the first evidence of "Referendum effects" weighing on the April PMIs, and we expect this trend to continue into May, with downside risks seen for the key Manufacturing and Services PMIs in particular, but a softening in Construction PMI as well. 16Q2 growth will be weaker than the 0.3% q/q that both the BoE and NIESR expect.” = TD Securities.

The Euro Next Week

The euro exchange rate complex has endured a poor month of May. To be fair, when faced with the pound’s short-covering rally and the US dollar’s bounce on Fed interest rate expectations, any positive developments in the Eurozone would have had little impact on the currency.

But, the debate on the Euro ultimately rests on the European Central Bank’s intentions over future monetary policy (will they cut rates again, will they boost quantitative easing again?) and driving this decision making is the rate of inflation.

The ECB has taken extraordinary steps to try and boost price growth. This week we find out if the measures are working and what the ECB thinks about the latest developments in the Eurozone and global economy.

Events to Watch

  • Tuesday May 31st: Inflation forecast by economists to have risen to -0.1% from -0.2% previously.
  • June 2: ECB Rate Decision

“The ECB is in implementation mode, so Thursday’s meeting should be a straightforward affair. However, the macroeconomic projections will be updated, and are likely to show an upward revision to inflation this year, which will reinforce the ECB’s move to the sidelines for the rest of the year.” - TD Securities.