Euro to Pound Sterling Exchange Rate Still Trading Above Fair Value, Must Therefore Fall

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The euro exchange rate complex remains under pressure and studies suggest that the EUR/GBP could fall further still.

  • “Price action continues to suggest 0.8117 was a top for a move back towards 0.73-0.72." - Lloyds Bank.
  • Were the exchange rate to be trading where we expect it to, according to interest rate differentials, it would be around 0.72 today.

The EUR to GBP conversion has fallen from a high of 0.8117, recorded on the 7th of April, to a low of 0.7564 recorded on the 25th of May.

The move has been widely attributed to markets short-covering their GBP-negative bets made when the prospect of a Leave vote in the summer referendum was at its highest.

As the prospects of such an eventuality fade, so the recovery in the British pound extends. The question that those with an interest in the market will now be asking is how far the move can extend.

Indeed, some will be asking whether the recovery is now over?

According to a simple, yet incredibly accurate study of the exchange rate rate’s relationship with interest rates, the answer would have to be that further gains should be expected.

The EUR/GBP rate tends to track the difference between Eurozone and UK interest rates - the rate differential. The difference in interest rates is important as money flows in either direction across the channel in accordance with where yields are higher.

The EUR/GBP therefore tends to track the difference in yield - because of the long-term correlation we can safely assume that this is how we can determine fair value for the exchange rate.

DNB Markets have today issued the following:

euro to pound exchange rate differentials

In short, were the exchange rate to be trading where we expect it to, according to interest rate differentials, it would be around 0.72 today.

Therefore more ‘Brexit premium’ needs to be erased, but we would only expect such a move to occur on the actual delivery of a Remain vote on June 23rd.

Markets Guilty of Becoming Complacent on EU Referendum

We have been warning for some time now that the pound's referendum-inspired recovery could be a case of overconfidence by markets.

This view has been strongly backed up by analyst Ned Rumpeltin at TD Securities who has written to clients suggesting the GBP should be sold in anticipation of the relief-rally running its course.

The note goes:

"It is premature, in our view, to think that the UK is out of the woods. 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. 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.

"To put last week’s uptick in sentiment into context, it is important to note that we’ve been here before. During the third week of April, we also observed a similar spike in expectations for a Remain win.

"But like in late-April, we saw last week a higher share of telephone polls (vs. online polls) in the headlines akin to the dynamics in late-April (see chart). As we’ve previously argued, this matters because the telephone polls have consistently favoured a Remain win by about ten percentage points. Online polls, in contrast, tend to be more carefully balanced and some have frequently pointed to a Leave win."

Further Declines in EUR/GBP Forecast by Technical Analysts

The EUR/GBP pair is set to move lower, after breaking through yet more levels of support and steepening its decline.

According to Yan Quenlann of online broker Swissquote, “EUR/GBP is still oriented downwards.”

The analyst notes: “Hourly resistance can be found at 0.7754 (intraday high) while hourly support can be found at 0.7565 (25/05/2016 low). The medium-term momentum is clearly bearish.”

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Robin Wilkin at Lloyds Commercial Banking, meanwhile, has come round to the view that the 0.8117 April 7 highs are a ‘top’:

“Price action continues to suggest 0.8117 was a top for a move back towards 0.73-0.72. Further evidence/ confirmation comes from a break through the 0.7500/0.7450 highs of last year.

“A rally back through 0.7750/0.7800 would negate this outlook and suggest the declines were just corrective for a re-test of 0.82, with a break there risking follow through to the next levels at 0.8370/80 and possibly 0.8700/20.”

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The outlook of Commerzbank’s Karen Jones is also bearish after analysing a head and shoulders (H&S) topping pattern with a downside target in the 0.7360s.

An H&S is composed of three successive peaks, the middle one (the head) of which is taller than the other two (the shoulders).

The H&S signals a reversal of the trend from up to down, confirmation is achieved with a break below the ‘neckline’ situated at the lows of the H&S’s troughs. This also makes the target live. This has already occurred on EUR/GBP

“EUR/GBP’s failure ahead of the neckline resistance coupled with the break below the .7654 is viewed very negatively. This has reinforced the head and shoulders top pattern which offers a downside measured target to .7360. Initial supports are the 50% retracement of the move from November 2015 at 0.7550 and the 200-day ma at .7523.”

Jones notes potential support slowing the decline at the 0.7753 23rd May high, however, this will likely be overturned reasonably quickly as, “The short term downtrend at .7838 maintains near term downside pressure. “

Commerzbank’s trading recommendation is to remain short (that means selling the euro to buy the pound, or betting on more downside in the pair).

Jones originally recommended going short at 0.7817.

She is now suggesting trader’s lower their stop loss from 0.7880 to 0.7850.

The final target is at 0.7360, she remains negative below 0.7945, and the pair should revisit the 0.7654 zone in 1-3 weeks.

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