GBP and EUR Market: Bullish Outlook for GBP Faces Market Resistance

Sterling continued to capture significant attention from analysts yesterday, with the Financial Times featuring a front-page story on the improvement in some analysts’ forecasts. The more optimistic outlook for GBP in the GBP and EUR Market, is based on the belief that the UK economy has displayed greater resilience than initially anticipated, external balances have improved, and, most importantly, the Bank of England will be compelled to raise interest rates to approximately 5%, regardless of policymakers’ preferences.

However, in a market that lacks clear direction, the bullish calls have faced considerable resistance, and even we are skeptical about the extent to which sterling’s outperformance can persist. The recent rise in the pound has primarily been driven by a reduction in net short positions rather than an accumulation of net long positions. Furthermore, we do not expect the Monetary Policy Committee (MPC) to meet market expectations of up to three additional rate hikes.

While the upcoming decision may be too early for the BoE to pause and strongly push back against market pricing, we anticipate the Bank to shift from its non-committal stance and pause its rate hiking cycle as early as June. Considering our view that the ECB’s terminal rate is higher than what the markets are pricing, we anticipate a retracement of sterling against the euro specifically over the next month, especially as it currently trades at a five-month high.

ECB’s Continued Commitment to Rate Hiking Cycle Amid Market Challenges

In the EU yesterday saw another day filled with commentary from the ECB, and the key message from all the speeches and interviews was the ECB’s continued commitment to its rate hiking cycle, signaling that the recent slowdown in the pace of hikes does not indicate an imminent end. As we mentioned yesterday, this aligns with our view that the ECB’s terminal rate is higher than current market pricing. However, it will likely require another round of robust core inflation data for the markets to fully embrace the ECB’s more hawkish guidance and adjust the implied terminal rate closer to our projection of 3.75%.

With ECB members’ statements having minimal impact on money market pricing, and in the midst of a broader risk-off environment, the euro faced challenges yesterday as it retreated towards the lower end of its recent trading range. Rate differentials continue to play a significant role in driving the single currency, and while eurozone rates are proving relatively stable, there could be some market reaction this afternoon based on US inflation data set to be released.

Any significant decline in core inflation, which would raise expectations of rate cuts, is likely to push EURUSD back to the upper end of its recent range, while a stronger reading would likely break yesterday’s lows. On the eurozone front, there is little of note on the economic calendar, except for comments from ECB member Madis Muller, who will be discussing financial stability at 09:00 BST.

US Dollar Strength Prevails as Equities Decline and Yields Rally

The US dollar demonstrated broad strength throughout yesterday’s session, even against other safe-haven currencies, as equities declined and yields rallied. Several ongoing narratives underpinned the cross-asset price movements. In the equities market, the real estate sector, particularly in Europe, underperformed after one of Sweden’s major commercial landlords postponed a dividend payment following a ratings downgrade.

With monetary policy transmission occurring more swiftly in Sweden, signs of weakness in commercial real estate acted as a warning for European realtors. Another factor weighing on equities was the renewed surge in short-term yields. The US 2-year yield climbed above 4%, driven by ongoing concerns about the US debt ceiling and positioning ahead of today’s inflation report.

Regarding the debt ceiling, despite discussions between House Speaker Kevin McCarthy and Joe Biden, no progress has been made in reaching a deal. Broad risk aversion was further fueled by the results of the NFIB measure of small business optimism, which historically has been an indicator of an impending recession. The continued decline in the index suggests that the likelihood of a US recession remains