Euro holds upper hand against British Pound on diverging ECB-BoE expectations

EUR/GBP edges higher on Wednesday, though price action remains confined to the narrow range that has been in place since late July, largely between 0.8540 and 0.8580. The Euro (EUR) holds a slight advantage over the British Pound (GBP) in the near term as expectations for European Central Bank (ECB) and Bank of England (BoE) policy move in different directions.

At the time of writing, the cross trades around 0.8561, up roughly 0.10% on the day.

Higher energy prices caused by the war in the Middle East prompted the ECB to raise interest rates by 25 basis points in June. Markets are now almost fully pricing in another increase at the September meeting, which would lift the deposit rate from 2.25% to 2.50%.

ECB Executive Board member Isabel Schnabel strengthened expectations of additional tightening on Wednesday. Schnabel said that inflation is likely to stay above the ECB’s 2% target for an “extended period,” while the Eurozone economy appears to be gaining momentum. She described the natural gas situation as “particularly concerning” and stressed that the central bank must act early to prevent second-round inflation effects.

In contrast, the BoE kept the Bank Rate unchanged at 3.75% at its latest meeting despite UK inflation staying above the central bank’s 2% target. Most policymakers judged that the tightening in financial conditions since the Middle East war began was providing sufficient protection against inflation risks caused by higher energy prices.

The BoE is widely expected to leave borrowing costs unchanged at its upcoming meetings, although markets still price in some possibility of a rate increase before the end of the year.

Analysts at Rabobank note that, “we expect further range trading in EUR/GBP over the coming weeks, with a mild upside bias later in the year as fiscal realism weighs and BoE rate hike risk is further priced out.”

Policy expectations are central to their cautious stance on Sterling. Rabobank reiterates that “it remains Rabobank’s central view that the MPC will continue to side-step a rate hike this year.” Since “the market still sees some risk of higher rates this year,” they warn that “steady policy, in line with our view, could undermine the Pound.” Against this backdrop, Rabobank “maintain a 3-month EUR/GBP forecast of 0.87,” consistent with their view that the cross will trade in a range before drifting higher later in the year.