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

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.