EUR/GBP: Likely To Grind Higher

The EUR/GBP currency pair, which expresses the value of the euro in terms of the British pound sterling, has held firm over the past few months. The trajectory is currently broadly constructive, indicating the potential for further euro strength against the British pound sterling. This pair is naturally sensitive to Brexit developments, or perhaps the lack thereof, considering that the year-end deadline for a formal EU-U.K. trade deal remains in full view. If there is no deal between the European Union and the United Kingdom by the end of December, the U.K. will be looking forward to a rather uncertain future.

In fact, at this stage, it is probable that the United Kingdom will be facing a rocky future regardless of whether a deal is secured. Biden has been reported to have won the presidency. Boris Johnson will therefore need to rebuild his relationship with the United States through President-elect Biden, after Biden’s team is inaugurated officially on January 20, 2021. This is, of course, post the EU-U.K. trade deal deadline. Boris Johnson’s relationship was strong with President Trump; it is arguable that Johnson’s standing in negotiations with the EU is now weaker without the “certainty” of Trump’s backing.

The U.K. is, for the first time (in a long time), “alone” in the world. That is to say, it is facing a future of newfound independence, which will not necessarily present immediate advantages. Advantages may accrue in the longer term, but in the short to medium term, I would hold that GBP is a riskier hold versus other major currencies, including EUR. As we saw in Q1 2020, GBP is also extremely sensitive to risk sentiment. Broad risk-off events tend to disproportionately affect GBP, while the lack of a trade deal is likely to push GBP lower by year-end. Broad USD weakness has recently enabled GBP/USD to hold firm, but EUR/GBP is likely to continue to grind higher regardless.

The EUR/GBP chart below illustrates price action through 2020. The black trendline has been added to show the generally positive trajectory.

(Source: TradingView. The same applies to price charts presented hereafter.)

As noted in my previous article covering EUR/GBP, fair value on the basis of Purchasing Power Parity was circa 0.96 in 2019. This is on the basis of the relative purchasing power of the euro in terms of British pounds. The euro has historically traded at a discount to the PPP-implied fair value price; given the uncertainty surrounding the service-led U.K. economy, it is conceivable that the greater economic unity across the European Union this year could reverse this premium. It is possible that GBP will start to trade at a discount.

Regardless, fair value is set to increase for EUR/GBP, as U.K. inflation data shows that the economy has been able to stave off deflation through 2020. Annual inflation was as low as +20 basis points in August 2020, but inflation picked up to +50 basis points in September 2020. The euro area, meanwhile, has found deflation in all three months of August, September, and October of 2020.

Euro Area Inflation Rate in 2020(Source: TradingView. The annual euro area inflation rate has dipped into negative territory from August through October 2020.)

Deflation, meanwhile, improves real yields. The ECB’s deposit facility rate of -50 basis points must therefore be adjusted for the latest inflation rate of -30 basis points, presenting a net negative yield of only -20 basis points. The U.K. short-term interest rate is currently set at +10 basis points (notwithstanding the fact that short-term gilt yields have dipped into negative territory several times this year). The recent year-over-year U.K. inflation rate of +50 basis points therefore provides GBP with an implied negative yield of -40 basis points. EUR/GBP, therefore, looks attractive on an inflation-adjusted basis.

The bond market does seem to indicate confidence in the U.K. financial system, however. This is probably due to the high level of Bank of England intervention, which has compressed gilt yields. When a country controls its own currency (monetary policy) and is not exposed to significant foreign debt, this is usually enough for bond markets to continue to function effectively. However, the increasing need for Bank of England intervention does put into question whether or not U.K. bond markets are truly indicative of confidence in GBP. Still, since the European Central Bank also intervenes heavily in EUR bond markets, perhaps this “intervention” factor cancels itself out, and we might therefore still be able to look to U.K.-German bond yield spreads as an indicator of sentiment.

As shown below, the 10-year yield spread between German (as a proxy for the euro area) and U.K. government bonds does still correlate with EUR/GBP. The yield spread is illustrated by the blue line; EUR/GBP is shown in red.

EUR/GBP vs. 10-year Yield Spread

The current spread of -89 basis points (illustrated above) compares to the short-term central bank rate spread of -60 basis points (i.e., the ECB deposit facility rate of -50 basis points, minus the Bank of England’s official rate of +10 basis points at present). Owing to this difference, I would suggest there is plenty of room for yield spreads to push higher in the short to medium term, which would strengthen the case for EUR/GBP upside (a weaker GBP). Should the Bank of England decide to cut rates to zero, or even into negative territory, the spread would widen further in favor of EUR.

The more “diversified” euro area shrank by a lesser rate in Q2 2020: by -14.8%, as compared to the U.K.’s negative rate of -21.5% in the same quarter. In Q3 2020, the euro area reported a year-over-year fall of only -4.3%, which indicates considerable progress. The U.K. is due to report its preliminary year-over-year figure for Q3 on November 12, 2020. EY estimate that U.K. growth (quarter-over-quarter) in Q3 will be over 16%, which would compare to the euro area’s quarter-over-quarter growth of 12.7%. However, the second month-long lockdown through December 2 (which could also be extended) during such a crucial period for consumer-facing businesses (leading up to Christmas) will likely punish Q4 growth. Arguably a shift to online shopping will also boost imports, which will further reduce U.K. growth, considering that imports are a negative component of aggregate demand.

In summary, EUR/GBP is probably still undervalued on a fundamental basis (per PPP modeling), while EUR also appears less risky than GBP in the current macroeconomic environment. Further, there does not appear to be any yield benefit to holding GBP over EUR after accounting for differing inflation rates. With the final Brexit deadline still in view (year-end), I would expect EUR/GBP to continue to grind higher through Q4 2020.

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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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