EUR/GBP: Driven by politics and rate hikes - Rabobank

There has been a choppy upward bias evident in EUR/GBP since late January and much of this had been unwound ahead of and on the back of the hawkish BoE policy meeting on February 8, before EUR/GBP headed higher again, explains Jane Foley, Research Analyst at Rabobank. 

Key Quotes

“Earlier this week EUR/GBP hit its firmest level since January 12.  Despite the likelihood of a 25 bps rate hike from the BoE in May we see risk that political uncertainty will continue to undermine GBP.  We see risk of a choppy move towards EUR/GBP0.90 on a 6 month view.”

“Last week the BoE offered a strong clue that it was prepared to hike interest rates soon and potentially to coincide with the May Inflation Report. A second rate hike could then be announced later in the year.  The risk of a rate hike as soon as May is in theory GBP supportive.  The driver for the hawkish position of the MPC appears to be the expectation that wage inflation is rising and that this will create additional demand.  Like the Fed, it can be argued that the Bank is currently more model driven than data driven and that its model is still based around the Phillips curve which assumes that tight labour market conditions will fuel higher wages which in turn will support domestic demand and generate upward pressure on prices.”

“Earlier this week a survey by the BoE's agents suggested that UK pay will increase by 3.1% y/y in 2018 compared with 2.6% y/y in 2017.   This supports the BoE’s hawkish position.  However, for demand driven inflation to rise, retail sales data will have to strengthen.  If either official average earnings numbers or retail sales data fail to trend higher, the market is likely to start doubted the ability of the Bank to hike rates twice this year.  This would be a setback for the pound.”

“This morning UK January retail sales registered a disappointing 0.1% m/m rebound following a revised -1.4% m/m drop in December. The soft data follows a report from Visa earlier in the week suggesting that overall consumer spending dropped in January on the back of a fall in high street shopping and weaker spending on transport. Growth in UK retail sales has been trended lower since late 2016 in line with softening consumer confidence.  In the main, this is likely the result of the fall in real wages.  This is largely a consequence of higher import prices caused by the plunge in GBP in 2016.  The Bank is assuming that real wages will again push higher this year on the back of labour market shortages creating excess demand and stronger inflationary pressures.”

“Interesting, the UK money market paid little attention to the poorer retail sales data this morning. This suggests a lot of market buy-in to the Bank’s concerns about inflation potential.  That said, for the Bank to be able to hike rates twice this year, we expect that an upward trend in official average earnings data will have to be confirmed.”

“All else being equal, the prospect of two rate hike from the BoE this year is GBP supportive. However, political uncertainty has the potential to trip up the pound.  In view of the divisions within PM May’s cabinet, the risk of a leadership election is never far below the surface in the UK.  Moreover, the prospect of another general election and a swing to the far left is also a tangible risk.  Layered in top of these concerns are a myriad of uncertainties about what sort of post Brexit trade arrangements will be put in place.”

“From late December into early January, GBP benefitted from the assumption that deal between the EU and UK on the Brexit legacies issues significantly reduced the chances of a hard and messy Brexit. It has become clear in the past few weeks, however, that there is still a sizeable distance between the two negotiating bodies regarding the Brexit transitions phase and the final arrangements regarding trade.”

“Given that Brexit is now only 13 months away, there is scope for anxiety over the outlook for the trade and transition talks to weigh on the pound in the months ahead.  It is our central view that there will be the bones of an UK/EU trade deal in place just before the March 2019 deadline and that this could trigger a significant rally in the value if the pound.  On a 6-9 month view, however, we see scope for EUR/GBP to creep up towards 0.93.”