EUR/GBP Daily Chart

EURGBP

The EUR/GBP daily chart shows a classic inverted head and shoulder formation on the daily chart positioned at the bottom of the six and a half year long downtrend. A breakout would open doors for a target of 0.7946. That is a 500 pip move above the neckline resistance; a move which appears likely on in case of a major shift in the monetary policy stance of either the BOE or the ECB.

Six months back, a report titled “Could BOE turn dovish and cut rates” (https://www.fxstreet.com/analysis/macro-scan/2015/03/25), wherein I had made a case for the possible dovish turn by the BOE and a possibility of an interest rate cut. Four main reasons were cited back then – Falling inflation (still a problem), Sterling exchange rate (still a problem), Risk of hung parliament in the UK (threat no longer exists), Delay in Fed rate hike (Fed rate hike now seen happening in December or March 2016).

Falling inflation is still a problem in the UK. Not that deflation is bad, but central banks targeting 2% annualised inflation makes it bad and thus decreases the odds of a rate hike. Moreover, the labor markets (represented by unemployment rate) in the UK have strengthened considerably, despite which CPI is threatening to dip in the negative territory. This leaves very little scope to hike rates, since any rise in the unemployment level post rate hike threatens to push the BOE further away from its 2% CPI target.

Sterling exchange rate too remains a major problem. In fact, in the last six months the negative impact of the GBP strength has become more pronounced. The drop in the exports is a concern, and thus, country risks loosing its share of exports amid aggregate demand deficiency in the global economy if the BOE hikes rates and leads to spike in the GBP.

The problem for the BOE only increased further after the Federal Reserve took a dovish turn in September and the ECB expressed its readiness to do more. The CME Fed watch data shows a 25 basis point hike happening only in March 2016. October is likely to be a non-event, while the probability of the December ate hike is very low. Moreover, Fed’s Yellen and other policymakers are trying hard to talk up rate hike bets, but markets seem to believe the other way round. In my personal opinion, the Fed rate hike is unlikely to happen this year. Consequently, the prospects of the BOE rate hike is very very low.

New factors that could force BOE to cut rates

Turmoil in the Financial markets – The panic with regards to China and heightened concerns regarding the global growth after the Fed’s dovish turn has rattled markets across the globe. Moreover, Fed not only kept rates unchanged, but did not even hint at a possible rate hike in 2015; an opportunity lost in my opinion. No wonder, the markets no longer believe what the Fed is trying to sell with regards to rate hike or inflation. A rate hike or a possible hint at a rate hike in near-term by the Fed would have provided stability to the markets. But, now even if they hike rates now, it would trigger more risk aversion; thereby taking BOE further away from the rate hike and more closer to a rate cut.

Aggregate demand deficiency is more visible now – In the last six months, it has become more evident that there is a need to re-develop demand in the global economy. China’s slowdown and the shift in the PBOC’s FX policy and interest rate cut followed by a retaliatory action by other Asian and EM central banks only highlights the battle for maintaining export share has resumed. The ECB also stressed its readiness to do more, while speculation that the BOJ may expand its stimulus next month is already on the rise. Consequently, it is difficult for the BOE alone to stay hawkish and/or hike rates.

Hence, the view stays intact that BOE is indeed likely to turn dovish and may actually tilt towards rate cut, especially since the bank has a 25 basis point room (interest rate currently at 0.50%) before it hits the zero lower bound.

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