ECB Race to the Bottom Could Cut EUR/GBP Rally Short

With the European Bank painting itself into a corner and UK fundamentals surprisingly picking up despite the pessimism surrounding the referendum decision, the EURGBP pair’s recent gains may give way to losses if monetary policy in the two regions diverges further.  An unfolding banking crisis in Italy and growing anti-austerity sentiment sweeping across Europe combined with ongoing structural deficiencies have made the Central Bank’s job of restoring inflation and above trend growth especially challenging.  Meanwhile, even though the UK has seen business investment and consumer confidence have tumbled amid the uncertain outlook, rising inflation and strong wage growth could see any hopes for further Bank of England accommodation quickly dashed.  The Pound has given up significant ground versus peers in recent weeks, but looks increasingly likely to reap the benefits of a sharp decline in European fundamentals, creating a catalyst for EUR/GBP to retrace much of the recent rally.

UK Inflation Climbs as European Confidence Wanes

The Bank of England chose to refrain from adjusting interest rates in its latest Monetary Policy Committee decision held earlier in the month, telegraphing to markets that it would consider renewed accommodation at the next meeting.  However, recent comments from MPC Member Martin Weale may have thrown cold water on that thesis alongside recent positive macroeconomic developments.  Weale, a traditional hawk on the MPC board, stated that there is no need to rush interest rate cuts with further evidence necessary first to determine whether or not rate cuts would be appropriate.  Data released earlier by the Office of National Statistics relating to inflation may have just dashed rate cut expectations, especially after figures showed that consumer and producer prices are rising faster than anticipated.

Even though Europe has flirted with deflation on multiple occasions, with the UK briefly slipping into deflationary territory during the second half of 2015, the Euro Area remains significantly closer to the threshold after the CPI printed at negative levels for three of the last five readings.  By comparison, the headline annualized UK figure rose to 0.50% in the latest print, beating expectations of 0.30% with core inflation rising at a 1.40% pace. Besides the fact that these numbers are outstripping their Euro Area peers by a wide margin, if inflation continues to rise at the current pace, a Bank of England rate cut may amplify the momentum higher at a time when the Central Bank may be more keen to temper the rate.  By comparison, the European Central Bank is expected to ease policy even further, especially in light of the restrictions posed by ongoing accommodation.

One of the main reasons why the ECB has been unable to move the needle on inflation is the severe limitations of the asset purchase program.  The ECB can only buy sovereign and corporate debt that is yielding above the interest rates charged by the deposit rate facility which currently numbers -0.40%.  With many of Europe’s bond yields trending significantly in negative territory, the available pool of assets to purchase is shrinking rapidly. Considering shrinking asset availability combined with no coordinated fiscal policy among the member nations comprising the monetary union means the ECB faces an uphill battle to spur inflation which currently stands at 0.10%.  This will likely force the Central Bank to contemplate more aggressive negative rates in an effort to limit the appeal of saving while encouraging spending.  This divergence in policy will likely find the EURGBP pair under renewed pressure, cutting the recent rally short.

Technically Speaking

Upon further review of the price action in EUR/GBP, recent gains have come amid increased bullish sentiment in the pair over the last 8-months after snapping of a multi-year downtrend.  The “golden cross” that emerged in the pair earlier in the year once the 50-day moving average crossed the 200-day moving average to the upside is a notoriously bullish occurrence that is normally accompanied by significant momentum higher.  A closer look at the moving averages shows that the 200-day moving average remains the more significant level of support for the upward trending price action.  However, despite the bullish signal produced by the “golden cross”, the relative strength index reached levels indicative of EURGBP being overbought, contributing to the recent pullback.  Now that a head and shoulders bearish formation has emerged, the stage might be set for prices to retreat even further towards the 0.8000 level which represents the 61.8% Fibonacci retracement.

Looking Ahead

Based on the serious variance in economic outcomes between the Euro Area and the United Kingdom, recent gains in the EUR/GBP may quickly turn to losses as Europe struggles to regain its footing.  The ECB’s dwindling tool kit combined with higher inflation in the UK, may see rate policy head in completely different directions.  Even though the BoE has telegraphed the potential for accommodation in its next meeting on policy, higher inflation may prevent any such development whereas the ECB might have to ease policy more aggressively to show any results amid the incoming turmoil from banks and sovereigns rejecting austerity.  Although the EUR/GBP pair is currently elevated thanks to a confluence of technical factors, a pullback towards 0.8000 is certainly possible amid the outlook for monetary policy in each region combined with the emerging bearish head and shoulders setup.