Foreign Exchange: Strategy
Limited Upside in EUR/GBP
Large gains in EUR/GBP from current levels appear unlikely. We favour a strategy of selling into EUR/GBP strength.
The UK economy is outperforming the Eurozone. This is feeding through to a divergent outlook for the ECB & BoE.
EUR/GBP is very interest rate sensitive. The German-UK two-year swap spread should remain negative and weigh on EUR/GBP over coming quarters.
EUR/GBP gains should be limited
In our view, large gains in EUR/GBP look limited. We would look to employ a strategy of selling into EUR/GBP rallies up towards 0.85163 (100-day moving average) into year-end. We continue to forecast EUR/GBP to ease back down towards 0.8000 by mid-2014. Our EUR/GBP forecasts are provided in the table below.
The macro fundamentals favour the UK
The macro divergences between the Eurozone and UK remain apparent. These differences should remain in place and risk broadening further. The fundamental backdrop should weigh on EUR/GBP over the coming year.
The UK side of the Equation
The UK economy appears to be entering a virtuous circle. Growth, driven by firming domestic demand, is looking robust. Activity indicators, such as the UK PMIs are at historically high levels and consumer and business confidence is picking up. The UK housing market is also undergoing a healthy revival. This is positive for UK consumption growth (chart 1). This positive economic outlook was highlighted in the Bank of England’s November Inflation Report. The BoE now sees UK growth over the 2014 calendar year at 2.8%pa. If realised, this would be the strongest rate of calendar year growth since 2007.
Significantly, the positive UK growth story is translating into a positive run in the UK labour market. The UK unemployment rate dipped down to 7.6% in September, this was its lowest level since April 2009. Given the positive growth outlook, the BoE now sees a greater than 50% chance the UK unemployment rate eases below its 7% unemployment rate threshold in Q3 2015. This compares to mid-2016 projected in its August Inflation Report. Interestingly, if a constant interest rate assumption was employed in the BoE’s November projections, as it was in August, the BoE forecasts a more than 50% chance the UK unemployment rate falls below 7% in Q4 2014 (chart 2).
It is worth remembering that the BoE’s 7% unemployment rate threshold is only a point where the monetary policy stance will be re-evaluated. It is not an automatic trigger for a BoE rate hike. This is a point which the BoE will continue to be stress going forward. Nevertheless, the faster projected pace of decline in the UK unemployment rate and broadening momentum in the UK economy suggests the process of monetary policy normalisation in the UK should occur before the ECB.
The Eurozone side of the equation
In contrast to the UK economy, momentum in the Eurozone economy remains fragile and uneven. A number of structural issues in the Eurozone remain unresolved, and these factors should act as a headwind to growth. One such issue is the fragmentation across the Eurozone banking system, which when combined with the record Eurozone unemployment continues to inhibit credit growth.
Furthermore, aggregate Eurozone inflation, at 0.7%pa, is now well below the ECB’s 2%pa target. While disinflation is primarily being driven by the Eurozone periphery, our estimated measure of core Eurozone inflation is now also tracking at a relatively subdued pace (chart 3). In its latest forecasts, the European Commission projected the Eurozone’s negative output gap to remain in place for an extended period (chart 4). The extensive spare capacity across the Eurozone economy should keep inflationary pressures across the Eurozone muted for the foreseeable future. This is the inflation sensitive ECB’s view as well. In November, ECB President Draghi indicated that the ECB is expecting a "prolonged period of low inflation".
Contrasting fortunes are a EUR/GBP negative
The contrasting economic fortunes of the Eurozone and UK are clearly illustrated via the “Eurozone-UK unemployment rate gap". The unemployment differential, as measured on a consistent basis via the Eurostat measure, is now at its widest since Q1 2005. With the UK unemployment rate set to fall further over coming months, and Eurozone unemployment yet to stabilise, this differential should widen further. Historically, a wider Eurozone-UK unemployment rate differential has tended to put downward pressure on EUR/GBP (and vice versa) (chart 5).
The diverging economic outlook between the Eurozone and UK is also being highlighted via the perceptions for ECB and BoE monetary policy. This is another factor that should limit EUR/GBP appreciation pressures. The shift in the BoE’s outlook for UK unemployment and the improving trend in the UK economy has moved the debate around the outlook for BoE policy to “when policy could be tightened"
Alternatively, the debate among market participants around the ECB is still centred on “if or when" it could provide more policy support. This comes despite the ECB having cut the refi-rate to a record low 0.25% in November. This view largely stems from the subdued nature of the Eurozone recovery and the weak inflationary outlook outlined above. Given this backdrop, it is hardly surprising the ECB continues to maintain an easing bias which is explicit within its forward guidance on interest rates. ECB President Draghi and other prominent members of the ECB such as Chief Economist Peter Praet continue to stress that there are options still in the ECB’s toolbox and that the ECB is not at its lower bound. One such measure is the possibility of cutting the ECB deposit rate into negative territory.
In sum, these macro differences should keep the German-UK two-year swap spread in negative territory for some time. This is significant, given the EUR/GBP cross is highly sensitive to moves in the German-UK twoyear swap spread (chart 6).
Added to this argument, the implied EUR/GBP rate estimated from our German-UK two-year swap spread equation is suggesting the current rate of EUR/GBP is more than 3.2% “overvalued" (chart 7). Deviations from the implied rate of this extent have been quite rare. Since 2010 such a divergence has only occurred 9.5% of the time (96 out of 1009 trading days). Notably, in the period since 2010, once this level of divergence between the implied and actual EUR/GBP rate has been reached, EUR/GBP has declined by 2% or more over the subsequent month 60% of the time (note: EUR/GBP has only risen over the following month less than 15% of the time once it has deviated from its implied rate by more than 3.2% ).