EUR: more downside likely on the back of growing demand for EUR funding. While we cannot rule out further easing by the ECB, we suspect that the Governing Council will take its time before announcing further measures. The fact that the ECB is targeting headline inflation may bring forward more easing especially if global commodity prices do not rebound anytime soon. Even if the ECB tries to preserve its ammunition for now, we think that demand for EUR funding should remain a drag on EUR/USD with international investors continuing to swap expensive USD-debt with cheap EUR-debt.
The flows in question could be quite sizeable - last year alone, the total issuance of EUR-denominated debt by non-residents amounted to EUR 90bn and we expect similar flow this year. Given that some of that will be used to run down expensive USD-debt, this could result in more EUR/USD selling from here.
At the same time, we expect that the EUR-buying by the Eurozone exporters will remain rather subdued for now as expectations of further EUR-weakness prevail in the markets. We think that EUR/USD could test and potentially break through last year's lows in coming months.
GBP - how much more downside ahead of the EU referendum. The latest GBP selloff seems driven by markets positioning for an EU referendum over the summer. After the December EU summit all eyes will be on the EU summit in February for potential indications that a 'deal' between the British government and its EU counterparts is drawing near.
The FX options markets seem to be pricing in a referendum as soon as June. Even if this were to be the case, however, the GBP-selloff seems somewhat premature, especially if we use the FX market price action ahead of major political events like the last two general elections and the Scottish referendum in 2014 as templates. Indeed, the price action would suggest that the political risks become an important driver only about three months ahead of the event. Also worth highlight that we are still to see evidence of decisive swing in favour of the Brexit camp in the polls. Our view is that Brexit will be avoided eventually. Political uncertainty ahead of the poll should remain an important negative for GBP.
This brings us to the other driver of the recent GBP-weakness - the disappointing economic data as well as the still weak inflation out of the UK of late. These forced the BoE to adopt a more cautious stance that emphasised further sustained GBP appreciation as an important risk. Despite all that, to us the BoE still remains very much data dependent, awaiting the bout of weak inflation to pass before deliberating rate hikes again. A lot of negatives seem to be in the price of GBP by now and we see a scope for consolidation but only in response to positive data surprises from here. Of particular importance would be the upcoming headline and core inflation as well as the average weekly earnings data.
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