EUR/GBP Could Pull Back

by: Hedge Insider

EUR/GBP has come full circle: after this author successfully predicted a drop in the EUR/GBP pair, the euro has risen on the back of increasingly favorable interest rate spreads.

However, the author believes that the recent surge has been aggressive, and the pair is now likely to stabilize around 0.88 as lower volatility is sought.

While interest rate spreads have risen, they remain largely negative, and thus the euro must still fight a fundamental headwind with respect to negative carry.

While euro-denominated assets have become apparently more attractive than sterling-denominated assets recently, this fuel that helped to sustain the fire of the recent rise in the euro is starting to cool.

Going forward, the author believes that EUR/GBP could potentially pull back, or at least stabilize, and upside (if any) is now likely to remain limited over the next few days, and possibly weeks.

It has been a while since I last wrote about the EUR/GBP pair. My previous article, entitled EUR/GBP: High Downside Risk, was published January 11, 2019. At the time, the pair was trading at about 0.90, and I projected a decline to 0.88 or so by mid-March 2019, before ever seeing 0.91.

As a recap, the chart below shows the publication date of my last article using the first vertical black line. The second vertical line shows the day on which my target was achieved: 17 January, 2019. The specific upper limit of 0.91 is also depicted using a horizontal line (ceiling).

EUR/GBP Drop (Chart created by the author using charting tools. The same applies to all subsequent charts presented herein.)

Yes, in just a matter of days, EUR/GBP fell precipitously through my price target. In fact, the price continued to fall a lot further. EUR/GBP then met my initial price target later (in mid-February 2019) as a source of resistance, before proceeding even lower to around 0.85.

Yet after multiple visits close to the 0.85 region, we are now back above my original price target, in June 2019. Why? The main reason appears to be rising interest rate spreads.

The euro is a currency used by a large number of powerful countries. Germany, France and Spain are three examples of countries within Europe that I would like to use. Looking at the spreads between the two-year government bond yields of these three countries versus the United Kingdom's prevailing two-year gilt yields, we can get a holistic impression of the "carry" (or relative attractiveness) of holding euros vs. the pound sterling.

EUR/GBP Spreads As you can see, while the prevailing interest rate spreads are negative for each of German (red line), French (blue line) and Spanish (yellow line) bond yields, in relation to UK bond yields, the spreads are rising. In other words, it is becoming increasingly unattractive to go long the pound sterling in terms of the euro, if we use the above spreads as proxies for the general, relative attractiveness of holding European currency or euro-denominated assets.

On the other hand, as these spreads remain negative, I do think that perhaps the euro has been a little too aggressive in its rise as of recent. It is probably unlikely that the euro will continue to surge higher, in the short term. The recent break higher in the EUR/GBP pair meant that the pair's volatility also surged, yet this is starting to tail off.

Using 20-day, two-standard-deviation Bollinger Bands, we can calculate the width of the Bollinger Bands. The width can be used as a proxy for volatility: the wider the width of these Bollinger Bands, the greater the volatility registered, and vice versa. As can be seen in the chart below (with the Bollinger Band Width indicator at the bottom), volatility has picked up, but is now tailing off back into "normal territory".

EUR/GBP Volatility As high volatility tends to beget high volatility, and vice versa, I believe EUR/GBP will now seek short-term stabilization, either by reducing the rate at which increases, or more likely by "turning back on itself" (i.e. falling) in the near term. It would make sense for the price to remain around 0.88 for the time being.

Further, per the chart below, you may see the relationship between European and British equities. The purple line (whose indexed-to-100 value is registered on the far-right y-axis) tells us how the values of European equity indexes for Germany, France and Spain and moving in relation to the value of the FTSE 100 (the preeminent UK equity index).

European vs. British Equities

Spikes in this ratio indicate a buying opportunity for the euro, in terms of pound sterling, since a rise in the relative (demonstrated) demand of European equities versus British equities tells us that the euro is likely to also become more attractive. In other words, the more that (primarily) "euro-denominated" assets become in demand, the more likely that the euro will become "in demand".

As you can see, spikes in this ratio usually signal a good time to buy the euro against the pound sterling. Right now, however, the ratio is tailing off. It is still high, yet it is setting lower highs most recently (although not quite lower lows). I would say the moves in this "index" of mine support the idea that the EUR/GBP pair will stabilization over the near term, and therefore the risk/reward does not look strong in either direction.

My current base case is neutral-to-negative for EUR/GBP for the time being. Also, as noted in a recent article of mine, I believe the pound sterling has been oversold. Upside for the euro is currently likely to be limited across the foreign exchange board.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.