EUR/GBP analysis: yield differentials matter
17:00, 17 January 2022
The pound's recent performance has been resilient to ongoing domestic political turmoil which has seen Prime Minister Boris Johnson's position become shaky in the aftermath of the Downing Street crisis surrounding holding parties during last year's Covid lockdown.
Following the Bank of England's (BoE) surprise rate hike in December, being the first major central bank to start normalising an ultra-loose monetary policy, speculators gradually reduced their short bets in sterling and have now priced in another hike in February as a done deal, according to the latest CME Group BoEWatch tool.
If the pound's rally against the dollar has been largely driven by positioning factors (short squeeze) and flows associated with a rotation from growth to value in equities, as discussed here, sterling's strengthening against the euro has remained largely driven by monetary policy divergences between the BoE and the European Central Bank (ECB).
Technical dynamics also started to play an important role, as EUR/GBP just broke out of a bearish channel it had been trading since April 2021. However, a rising Relative Strength Index (RSI) might indicate a waning of the bearish pressure on EUR/GBP in the recent sessions. This Wednesday's UK CPI is a key data to watch for further updates on market expectations on BoE's policy tightening.
EUR/GBP fundamental analysis
Price actions on EUR/GBP have been linked to the short-term yield differential between the UK and Germany over the past quarter.
The spread in yields on the two-year bond maturity increased to 142 basis points at the time of writing, the widest level since January 2019, reflecting a growing monetary policy divergence between the BoE and the ECB.
EUR/GBP (inverted) vs UK/Germany 2-year yield spread – Credit: TradingviewConsumer price inflation increased similarly in the UK and the EU during the last year, although the two central banks recently took differing views on the inflation pattern. While hawks currently dominate the BoE’s board, after eight out of nine members voted in favour of the December rise, doves continue to fly in Frankfurt, after recent assurances from top ECB officials that inflation would return to the medium-term objective.
The BoE's November forecasts predicted consumer price inflation of 3.5% in 2022, before falling to 2.25% in 2023, slightly above the Bank's target of 2%. In December, the central bank raised its expectations for inflation peaking to around 6% in April 2022.
Instead, the ECB believed in December that price pressures may have already peaked in the fourth quarter of 2021 and that, despite a higher for longer inflation, it should fall slightly below the 2% target by the end of 2022 and stabilize around 1.8% in 2023 and 2024.
UK and EU CPI rates and latest central banks' projections – Credit: KoyfinGoing forward, monitoring inflation dynamics in the two areas will be crucial for EUR/GBP, as factors such as the energy crisis in Europe or supply chain disruptions due to Omicron may complicate the forecasts of the two central banks.
The Office for National Statistics (ONS) will release the United Kingdom's December consumer price index statistics on Wednesday. The consensus forecasts a year-on-year increase of 5.2%, up from 5.1 percent in November, but a higher-than-expected print might rekindle market expectations for a more aggressive hiking cycle by the Bank of England, reviving speculations on the pound.
On the other side, the market is not yet pricing in even a slightest a change of position of the ECB, and if this were to come later this year it could generate a marked re-pricing of EUR/GBP upwards.
EUR/GBP technical analysis
EUR/GBP (1-day chart) technical analysis – Credit: TradingviewSince about April 2021, the EUR/GBP pair has been trading in a downward channel, which was just breached on 4 January 2022.
While both the 50-day and 200-day simple moving averages (SMAs) are drifting southwards in the daily chart, the RSI has just recently begun to rise from a neighbouring oversold position. These movements might suggest a waning of the bearish momentum, raising prospects of a EUR/GBP bottoming out around the 0.8320 support level.
The next resistance mark is around 0.8390 (0.236 Fibonacci retracement level from December's highs), and a break above it might raises the chances of further advances to 0.8490 (a 0.382 Fibonacci retracement) and then to 0.846 (0.5 Fibonacci).
An improvement in the pound sentiment in the case of a higher-than-expected UK inflation on Wednesday might restore negative pressure on EUR/GBP, potentially driving the pair to test the support level of 0.8320 and, in the event of a breakout, to the February 2020 lows (0.8282).
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