EURGBP Inflection Point
EURGBP has approached multi-month support around 0.8500 despite the fact that the interest rate differential between the two currencies has narrowed the yield advantage of GBP over EUR. In the background, both the ECB and BoE have been keen to lay the groundwork for modest interest rate reductions starting during the summer. Growth (or rather insufficient growth) is obviously a key driver of their policy preference, but the hope and assumption has been that inflation is still on a downward trajectory towards their respective 2% medium term targets in both Central Bank jurisdictions.
Headline UK CPI released on 22nd May certainly fell, but not as sharply as anticipated, challenging that narrative in the short term, with the services inflation component being particularly jarring.
UK Services Inflation was expected to fall rapidly but failed to oblige…
…causing SONIA (the three months futures contracts for GBP) to shift across the curve*. Note, Sonia for December 2025 increased by 15bpts, taking its total rise for the year to >90bpts. In other words, 15bpts less easing by the end of 2025 than had been priced the day before UK CPI as released.
*(lower price = higher yield…expressed as 100-yield).
What intrigues us is the relative interest rate differential with Germany. This differential has been narrowing since last summer but has not had a weakening effect on the Pound vs the Euro.
If narrowing differentials had no deleterious effect, what if the differential were to begin widening again? The ECB seems hell bent on cutting rates in June, but the BoE MPC may now find itself constrained by the better growth outcomes evident this year and sticky inflation. Note, their Anglo-Saxon cousins down-under, (actually both Australia and NZ) are revising their own rate expectations with hints of possible rate hikes back on the table.
A forced delay could end up being GBP supportive in a world which remains sensitive to carry. In fact, GBP’s yield advantage adjusted for realised volatility is quite impressive. Implied volatility is approaching lows last seen in the era of complacency which persisted in the run-up to the GFC in 2007. It is currently trading at barely over 4% in the 3-month tenor. Skew is fairly neutral in a historical context but on the lower end of the recent range, with EUR upside slightly better bid than EUR downside for 25 delta risk reversals.
Lastly, the upside surprises in growth, inflation and interest rates combine with what looks like the beginning of a reappraisal of UK stocks. FTSE is loaded with cyclical stocks and has garnered attention recently with mining stocks and banks perking up. Of course, one can hedge out currency risk when buying UK equities, but if GBP starts to move positively, this is less likely to be an attractive or necessary option. Further, UK stocks are heavily under-owned by international investors, not least because of the constant drip of negative media coverage of post-Brexit UK and the dismal showing by the incumbent Conservative Government which has just been bundled into calling a snap general election on 4th July.
Trade:
Sell EURGBP a 0.85. First target 0.82. Longer term targets sub-0.80. Stop above 0.86.
To take advantage of the cheapness of the option market, buy 3-month 25-delta downside in EURGBP ~4% implied, spot reference above 0.85 for just over 0.3% of notional. This tenor also takes you through the newly announced general election which could provide some good gamma hedging opportunities.