EUR/GBP Forecast: Rate Convergence Signals Further Pound Weakness

Analysts at Nomura reiterate their bullish outlook on the EUR/GBP exchange rate, anticipating further weakness in the pound sterling as UK interest rates converge with those of the Eurozone. This assessment follows recent UK employment and inflation data releases that suggest a steady decline in UK rates.

UK Economic Data Points to Rate Convergence

The Bank of England is expected to lower interest rates again in March, with money market pricing indicating another reduction by mid-year. This easing of monetary policy will offer some support to the UK economy. However, the European Central Bank (ECB) has concluded its rate-cutting cycle, leading to a narrowing of the interest rate differential between the UK and the Eurozone. This convergence is a key driver behind Nomura’s bearish outlook on the pound.

Nomura’s EUR/GBP Trade Recommendation

Nomura has increased its conviction in a trade to sell the pound against the euro, raising it to a 5/5 conviction level in January. The bank targets a move in EUR/GBP to 0.8950, which translates to a GBP/EUR target of 1.1170. Nomura Research Analysts Dominic Bunning and Yusuke Miyairi argue that UK wage and inflation data continue to point towards this monetary policy convergence.

Inflation Dynamics and Potential for Further Rate Cuts

The probability of a March rate cut increased significantly after the UK’s headline CPI inflation fell to 3.0% in January. While markets anticipate another rate cut, taking Bank Rate to 3.25%, analysts at Peel Hunt suggest that inflation dynamics could necessitate further reductions, potentially leading to a re-evaluation of market expectations and further downward pressure on sterling. Recent UK inflation figures have slightly reduced the probability of a March rate cut, mainly due to stickier services inflation.

Political Risks Add to Pound’s Headwinds

Rising UK political risks are also seen as underpriced and supportive of Euro outperformance versus the Pound. A potential loss for the Labour Party in an upcoming by-election could increase pressure on Prime Minister Starmer and raise the likelihood of a leadership change, potentially introducing less market-friendly policies. This political uncertainty adds another layer of risk for the pound.

Counterarguments and Potential Support for the Pound

Despite the prevailing bearish sentiment, some analysts believe there are factors that could limit the extent of the pound’s weakness. JP Morgan suggests that the Bank of England may be constrained by persistent inflation, preventing it from cutting rates aggressively. Handelsbanken also anticipates a potential rise in UK inflation later in the year, which could provide cyclical support for the pound through the carry channel.

Stubborn Services Inflation Remains a Concern

Digging deeper into the inflation data, concerns remain about stubborn inflation dynamics, particularly in the services sector. Services inflation, currently at 4.4%, remains above a level consistent with a sustained fall in overall inflation to the Bank of England’s 2% target. Business surveys indicate that underlying cost pressures remain sticky, and medium-term inflation expectations are still elevated.

Looking Ahead

While several headwinds face the pound, the potential for the Bank of England to be constrained by inflation could limit the extent of its weakness. The convergence of interest rates between the UK and the Eurozone, coupled with rising political risks, continues to support a bullish outlook for the EUR/GBP exchange rate.