Will ECB and BoE hawks drive the euro and pound resurgence?

With the ECB and BoE shifting into a more hawkish stance, it’s worth asking the question whether we are going to see the pound and euro bottom out after years of depressed price action.

Mario Draghi
Source: Bloomberg

We have seen a significant shift in tone and behavior from the European Central Bank (ECB) and Bank of England (BoE) in June, with the 2017 gains in EUR/USD and GBP/USD being driven higher yet. To an extent, the dovishness of the ECB and BoE has been taken for granted, with the fear of Brexit repercussions and the seemingly endless cycle of political and economic crises in the eurozone. However, with this recent shift comes the possibility of a long-term trend shift for the pound and euro. The journeys to this point are wildly different in both cases, yet it seems we are finding a convergence in terms of policy outlook as we see what the end of the ‘currency wars’ begins to look like.

Bank of England

The enactment of article 50 back in April seemed to have a detrimental impact on business and consumer confidence, knocking output and retail sales figures. To a large extent it seems as though firms have been awaiting article 50 to make key hiring decisions, with the services sector in particular suffering according to recent PMI surveys. Given how heavily influential the services sector is on UK growth, the recent deterioration in GDP was almost entirely due to a slowdown in services sector growth. To some extent we have seen a slowdown in the UK, but much of the reasoning behind expectations of a dovish BoE is to do with the potential for further deterioration during or after Brexit negotiations.

On the flip side, we have a worrying inflation picture, with a headline consumer price index (CPI) reading of 2.9% and core figure of 2.6%. Remember that the BoE mandate necessitates a rate close to 2%. Much of this has been driven by the value of the pound, which is at rock bottom levels by historical standards. A weaker pound means imports are disproportionately more expensive, which in the current global marketplace will impact both direct goods being bought, and the inputs for UK goods. With the recent rise in both headline and core CPI, it is worth noting that businesses are not raising wages anywhere near the same extent, thus leading to a rapid decline in real wages and disposable income.

We find ourselves in a position where the BoE has to choose between risking further economic slowing, and the potential for a major inflation overshoot. According to recent tones from the BoE, there is a gradual shift towards the notion that a rate rise could be necessary, with a view to regaining the upper hand on inflation expectations. This would provide the BoE with a tool to utilise once more if the economy took a turn for the worse. The June BoE meeting saw three of eight members vote for a rise, yet within these, it is worth noting that Kristin Forbes, the only consistent rate rise voter of the three, drops out of the voting process for the next meeting. Thus, while we are not close to a rate rise yet, the picture is gradually shifting towards a more hawkish one. If we see data improve over the coming months, there is reason to believe we will see rate expectations shift accordingly. However, be aware that continued economic weakness, as evident in this week’s PMI numbers, coupled with a dovish shift in BoE votes could see the bears come in once more for the pound.

Looking at the GBP/USD pair, we have seen the 76.4% retracement ($1.3059) forming resistance over recent months. The rising wedge points towards a potential for a move lower from here. However, the bullish signal we would be looking for, to set up a strong second half, would be a break and close above $1.3448. This would create the first higher high in almost three years. Thus, the risk of a dovish swing for the BoE brings the potential for this 76.4% to provide a strong bearish sell signal with the wedge formation expected to lead to a fall. However, should we see enough economic strength and hawkish rhetoric, a break through $1.3448 would signal a period of strength for the pair.

European Central Bank 

On the opposite side of the coin comes the eurozone, which has been in rude health of late. The ECB has had to place itself in a heavily accommodative position through the years, with economic and political crises coming thick and fast. However, with the Dutch and French elections out of the way, and the German polls pointing to a clear win for Angela Merkel, the risks are diminishing. On the economic side, we have seen a sharp appreciation in growth, PMI surveys, and confidence in the region. This is set against an environment where the ECB has embarked on a major policy of low-to-negative interest rates and consistent asset purchases which points to a shift from the ECB at some point. Mario Draghi has previously noted that any tapering of asset purchases will have to be laid out in advance, and thus while the likes of the Federal Reserve and BoE could arguably raise rates, the ECB will need to wind down their quantitative easing (QE) programme first as it takes time.

Looking at the EUR/USD chart, it is clear that we have run into a massive area of resistance, set within a near three-year range. The descending trendline ahead is certainly a key consideration, yet the crucial breakout needed to have longevity in terms of implications would be a break through $1.1715. This could portray the 2015-to-present range as a triple bottom formation. Some would utilise the trendline itself, hence the importance of this trendline. However, it is also important to see a higher high and break from this range-bound zone.

In summary, we are close to crucial junctures for both the pound and euro amid a seemingly shifting monetary policy landscape. However, these tentative signals need to be followed through for the market breakout to come. For the BoE, we will need to see an improved economic picture, and with Forbes leaving the voting committee, there is reason to believe we could see the dovish outlook return once more if data continues to deteriorate. On the flip side, the ECB still hasn’t even set out when they will begin to taper asset purchases, let alone raise rates. However, after a period of constant jawboning from Mario Draghi, there is a potential springback in the offing once we see the process laid out. That being said, the monetary policy picture will remain comparatively looser than the likes of the BoE and Fed for some time yet, and until we see resistance broken, there is always a chance that the euro bears will step in once more.

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