Pound to Euro Forecasts: Why GDP Divergence Signals a Soft 2016 for the British Pound

Is it any wonder markets are selling the GBP against the EUR - just look at how economic growth is projected to play out over the year ahead.

Citi forecasting a tough year for sterling in 2016

What a tough time those with outstanding euro payments have had thus far in 2016.

The news on the pound to euro exchange rate just goes from bad to worse. In fact, the momentum lower is so ingrained that a break below 1.30 is now forecast by some.

But why are markets so negative on sterling at the moment?

Firstly 2016 has thus far been characterised by negative market sentiment.

In ‘risk-off’ scenarios it appears that the euro and dollar are both favoured above sterling, so when markets sell-off so does the British pound.

Note of course that GBP sits above a stack of other currencies in the risk ladder, hence why we are seeing good gains against the NZD, AUD and ZAR.  

Fundamentals Count

Looking forward, we must take into account another very important factor: The paths being taken by the UK and Eurozone economies.

Ultimately the strength of the respective economies will determine policy settings at the relevant central banks which will in turn feed into exchange rate levels.

UK GDP Forecasts Downgraded, Massive Risks in 2016

The UK is set for modest growth with very low inflation (well below the 2% targeted by the Bank of England) in 2016.

Citibank’s economic research team have told clients of the bank that they are cutting growth and inflation forecasts for the UK further, and now look for 2.0% GDP growth and 0.5% CPI inflation in 2016.

Previously they had forecast growth at 2.3% and 0.8% respectively.

The forecasts sit below the Bank of England’s and consensus forecasts amongst economists for both measures.

Citi say they continue to expect the MPC will keep rates on hold throughout 2016.

“The main risk facing the UK is the EU referendum, and a vote for Brexit would probably cause a major political crisis and significant economic weakness in the UK,” say Citi, “If this risk is averted, the UK in coming years probably will, for the first time in decades, combine sub-5% unemployment and low inflation on a sustained basis.”

Eurozone GDP Forecasts: A Strong 2016 Beckons

Meanwhile recent data releases provide confirmation of the ongoing cyclical recovery in the euro area.

Real GDP had continued to grow in the third quarter, while other incoming information, including the latest survey evidence available up to November 2015, remained consistent with a continued moderate economic recovery.

Citi analysts expect the euro area to experience slightly faster and above-trend growth in 2016-17, thanks to the continued support from three main tailwinds: lower oil prices, fiscal policy loosening and an accommodative ECB.

Should the euro area continue to impress we will likely see currency traders increasingly buy the shared currency.

There are Downside Risks for the Euro Though

Note though that forecasters had expected a stronger pound to euro exchange rate in 2016.

Despite the ructions in the market this scenario could still play out.

Indeed, Citi say there are downside risks to the euro which stem from a potential unravelling of the European Union framework, either due to Brexit and/or a poorly-managed migration crisis.

“Close monitoring will be required with respect to political developments, not only France and Germany that will be gearing up for elections in 2017, but also in the periphery where inconclusive election outcomes in 2015 could lead to new rounds of national elections,” say Citi.

Although the ECB argues it has done enough with December's monetary easing, Citi Analysts suspect that the persistent undershooting of its inflation target will prompt a further adjustment of its asset purchase programme and more deposit rate cuts.

Citi exchange rate forecasts suggest the euro to dollar exchange rate will average around the 1.11 area in the first half of 2016 before falling to 1.03 at the end of the year.

The euro to pound exchange rate is forecast to rise to 0.74 by the end of the first quarter 2016 and will end the year at 0.71.