EUR/GBP probing annual lows in 0.8380s weighed by risk appetite, central bank poliy divergence

Despite holiday-thinned liquidity conditions in global and European currency markets on the eve of New Year’s, EUR/GBP has slipped under 0.8400 to probe annual lows in the 0.8380s. That translates into on the day losses of about 0.3%. The pair has been under heavy selling pressure since hitting highs last week in the 0.8550 area and at current levels, trades nearly 2.0% lower from these peaks. A surge in risk appetite amid a rush to price out Omicron-related economic pessimism amid numerous studies showing the variant to be far milder than previous strains has aided the risk-sensitive GBP and weighed heavily on EUR/GBP.

Meanwhile, the fact that the UK health case system currently has not yet shown any signs of being overwhelmed despite rampant Omicron infection in the country means that, so far, UK policymakers have refrained from putting England back into lockdown. Prior to the recent surge in risk appetite, the UK had been viewed as the Omicron epicenter in Europe, a perception that had weighed on GBP at the time and contributed to EUR/GBP hitting highs near 0.8600 earlier in the month.

A subsiding of perceptions of the risk posed to the UK economy’s near-term outlook by the rapid spread of Omicron has given FX markets the green light to price in a more hawkish than expected BoE. Recall that earlier in the month, the bank surprised some market participants by hiking interest rates by 15bps and indicating that more is to come in 2022. At the time, GBP struggled to benefit as traders worried the BoE would fail to live up to expectations due to Omicron disrupting the UK recovery. But now pandemic risks are subsiding, central bank divergence may return as a key FX market driver in 2022.

As emphasised in characteristically hawkish commentary on Thursday from ECB policymaking hawk’s Klaas Knot (Dutch central bank head) and Robert Holzman (Austrian central bank head), there is a healthy debate going on at the ECB about its timeline for monetary policy normalisation. A growing throng of policymakers appear concerned about upside risks to the bank’s inflation forecast for 2023 and beyond (which currently sees inflation falling back under 2.0% in order to justify ongoing stimulus). Recall the bank decided it would temporarily increase the pace of QE purchases under the pre-pandemic APP in Q2 and Q3 to make up for the end of the PEPP at the end of Q1.

The bank said it would continue with APP purchases for as long as necessary, but if inflation continues to surprise to the upside in 2022, it seems likely these might be ended by the end of the year. A hot flash December inflation report out of Spain on Thursday raises the risk of an upside surprise from next week’s Eurozone aggregate flash December inflation estimate. This increases the likelihood of upside surprises in 2022.

The ECB is clearly on the road to monetary policy normalisation, as are other major central banks, but even if inflation surprises do force it to unwind stimulus at a faster pace, the bank remains well behind the BoE in this regard. Thus, any potential hawkish ECB pivot may struggle to result in lasting EUR/GBP strength. While holiday-thinned trading conditions mean that a sustained downside break of the annual lows in the 0.8380s seems unlikely on Thursday or Friday, the level is vulnerable to being broken in the new year.