The pound has suffered significant losses against the euro over the last few months, particularly after the conservative party lost its majority in parliament on the last UK elections. The British government's negotiating power before the EU was thereafter dented and markets begun pricing in a "worst case scenario". As a result, sterling fell over 10% against the single currency, also becoming one of the worst currencies of the G10 over the last 12 months, only behind the Japanese yen.
Looking ahead, however, it appears that sterling could rally against the single currency. Technical indicators have set up for a dip in EURGBP (URGB), and now it is time for fundamentals to support this landscape-or reject it.
From the technical point of view, both the Relative Strength Index and the Slow Stochastics have aligned for a dip in EURGBP. The last time this happened, sterling rallied over 7.5% from 0.90 to 0.83 against the euro (chart below), although the political context was different at the time.
This week is critical as sterling's data could reignite the debate of a possible interest rate hike by the Bank of England in the UK. The British consumer price index has increased to 2.9% in August, just below the BoE's highest inflation forecasts for the post-Brexit period of 3%. Should inflation jump above the 3% threshold, markets would begin to price a hike aggressively. This could be seen by the implied market probabilities of a hike before the end of Q2 2018 as reflected by the overnight index swaps curve in the chart below.
If labor market data confirms expectations for an increase in wage growth, fears of a further domestic consumption crunch will ease, as real wage growth will improve. This could increase further speculation on an interest rate hike as soon as Q1 2018, as was also pointed by the NIESR last week after lifting its growth forecasts for the third quarter of 2017. The NIESR says: "If indeed economic growth is sustained at the 0.4-0.5 per cent level, we prescribe a 25 basis point increase in Bank Rate in the first quarter of 2018 to reverse some of the emergency stimulus that the Bank of England injected into the economy last August in response to the EU referendum result"
The "hard Brexit" story remains a concern for markets. However, looking at the correlation between GBP and the amount of hard Brexit publications in media (source: Bloomberg), it can be seen that Brexit headlines have a minor impact on GBP crosses (chart below)-especially in GBPUSD (NYSE:FXB).
I believe sterling will have some additional upside potential in coming weeks as fundamentals return to the UK and speculation on the timing of an interest rate hike begin to be priced in. Besides, the single currency (FXE) could retrace in broad terms as there is a substantial lack of macroeconomic data over the next few weeks and markets turn their attention to the German elections. In my opinion, ECB officials could also try to verbally talk down the euro over the next few weeks, ahead of announcing any decision at the October's meeting.
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