The pound has outperformed alongside other European currencies this month benefitting from the significant improvement in investor sentiment towards the region. It has helped to lift cable back up towards the 1.3000-level for the first time since last year’s US election. In contrast, the pound has weakened modestly against the euro lifting EUR/GBP back above the 0.8400-level for the second time this year.
The euro is expected to benefit more than the pound from Germany’s plans for looser fiscal policy. The last time EUR/GBP rose above 0.8400 in January it was driven more by negative sentiment towards the pound reflecting concerns over UK government debt.
Market participants now expect monetary policies between the ECB and BoE to diverge less going forward which has helped to narrow yield spreads in favour of a stronger euro. At the ECB’s last policy meeting they left the door open for further modest rate cuts with the policy rate now closer to the neutral estimate put forward by President Lagarde between 1.75% and 2.25%. Based on our assumption that legislation is passed tomorrow to boost fiscal policy in Germany, it will ease pressure on the ECB to lower rates below neutral.
The main risk to that view would be a much bigger hit to growth in Europe from President Trump’s upcoming plans for trade tariffs in early April. The EU’s decision to quickly retaliate by imposing tariff hikes from next month on EUR 26 billion of US imports in response to US tariff hikes on steel and aluminium imports has angered President Trump, and he has since threatened to impose 200% tariffs on over USD10 billion of alcohol imports from the EU. In contrast, the Trump administration has praised the UK government for their decision not to retaliate. It will further encourage market expectations that the UK economy will not be hit as hard by further tariff hikes in the coming months.
Market expectations for BoE policy have recently been relatively more stable than for the ECB. The UK rate market is still expecting the BoE to stick to the current quarterly pace of rate cuts by delivering the next rate cut in May (19bps of cuts priced in) and then again in August (44bps of cuts priced in). However, there is less confidence that rates will fall further below 4.00% by the end of this year. It is helping to keep yields in the UK at higher levels than on offer in other major economies providing support for the GBP.
The BoE holds their latest policy meeting on Thursday. Ahead of that meeting UK economic data has been improving with the exception of Friday’s softer UK GDP report for January. Overall it points to strengthening growth momentum since late year. At the same time the slowdown in services inflation and wage growth remains frustratingly slow. It will become more uncomfortable for the BoE to keep cutting rates heading into the summer when inflation is expected to temporarily pick up towards 4.0%. Overall, the pound remains attractive. A deeper sell-off for global equity markets that undermines financial stability poses the main downside risk for the pound. Please see our latest FX Weekly (click here) for more details.
