Is EUR/GBP on the cusp of a multi-month sell-off?

EUR/GBP looks likely to continue its decline, with fears over a dovish BoE and economic weakness likely to be ill-founded.

The pound has seen some selling pressure come into play over the first two weeks of January, with the widely anticipated Brexit boost somewhat failing to gather momentum. There are a number of reasons for this, ranging from expectations of an impending rate cut to the somewhat uninspiring data that has been released post-election. However, there are plenty of reasons to believe we will see the pound outperform in the months ahead despite these fears.

Will the BoE cut rates?

The Bank of England (BoE) has been rather inconsistent with their communication through recent years, with BoE Governor Mark Carney notifying markets of the possibility he could both raise and cut rates in the wake of Brexit. Ultimately, he was likely to be playing a guessing game owing to the lack of knowledge on how the pound would react and where inflation would be as a result. The sharp decline in sterling did not happen, and thus the UK has not seen imports jump up in price to drive inflation above their 2% target. We now see a marginal propensity to consume (MPC) that appears anxious about a slow recovery and below-target inflation. This dovish tilt has led markets to believe we could see a rate cut on 30 January, with market pricing in a 55% chance of such a move. Whether that comes to pass or not remains to be seen, yet it is worthwhile noting that any such move to ease would likely be short-term in nature. Thus any short-term declines in the pound around a single rate cut could actually provide a buying opportunity rather than the beginning of a long-standing period of weakness.

UK economic data in focus

Markets have been very reactive to recent economic data out of the UK, with particular attention being paid to those numbers in relation to the month of December. Of those December number, the sharp decline in claimants, consumer confidence, and a welcome upward revision in the services purchasing managers index (PMI) do provide a hint that improvement could be looming. Certainly, many will have looked towards the decline in inflation as a reason to see the BoE act, yet there are certainly some green shoots appearing for the UK economy.

The year ahead

There are worries looming over exactly how the UK will fare in trade talks this year, with UK Prime Minister Boris Johnson's hardline stance on the deadline for the UK’s exit raising fears that any deal will be insufficient. However, that is unlikely to be a drag until later in the year, with markets instead likely to be fixated with the interest rate path and the UK recovery (or lack thereof). Should we see the BoE take rates down to 0.5% this month, it would lessen the chance of a dovish theme in the following months. Rates are already very low, and any further cuts are likely to be very limited as a result. Thus with the economy likely to pick up and any short-term dovishness at the BoE likely to be short lived, there is a strong chance that the pound is on the cusp of a bullish phase.

Sterling bulls likely to return

The monthly EUR/GBP chart highlights the major sterling outperformance throughout the past five months. This brings us back into the £0.8304 level, which represents the last bastion for the pair. Below that point, we are looking at a significant area with very little support levels of note. That huge surge through 2016 represents the post-referendum move which is based upon the notion that the UK economy is set to shrink markedly in a post-Brexit world. Should we instead see the UK economy grow, it would make sense to expect some of those EUR/GBP gains reverse significantly.

The weekly chart highlights how the recent rebound has taken the pair back into trendline resistance, with the price heading lower since. This raises the possibility of a breakdown below that £0.8304 support level. As such, it looks like a very strong possibility that the pound strengthens in the coming months, with a decline below £0.8304 providing that bearish signal.

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