Pound's Rally vs. Euro Uncertain Amid UK Wage Data, ECB Stance

Key Takeaway

• The British pound's recent strength against the euro may falter if UK average hourly earnings data disappoints, with a 50% chance of a BOE rate cut by September.
• Political risk in France has increased euro volatility, with one-month volatility rising to almost 6%, and traders pricing in potential EUR/USD declines.
• ECB is unlikely to cut rates further amid rising inflation and political uncertainty, especially if the Fed fails to deliver anticipated rate cuts.

Pound's Recent Performance

The British pound has recently shown strength against the euro, driven by political uncertainties in France. The EUR/GBP pair moved lower, breaking out of its recent ranges. However, this momentum may be at risk if upcoming UK average hourly earnings data disappoints. A downside surprise in earnings could shift focus back to rate differentials, potentially weakening the pound. The Overnight Index Swap (OIS) market currently prices in slightly more than a 50% chance of a Bank of England (BOE) rate cut by September. This has led to speculators, particularly leveraged funds, building long GBP positions at a faster pace than the euro over the past four weeks.

Political risk in France remains a significant factor for the EUR/GBP pair. As this risk diminishes, central bank dynamics are expected to regain prominence. This shift could favor the euro, as current rate differentials suggest that the recent move in the pound may be overstretched.

Euro Volatility and Political Risk

The euro has experienced increased volatility following the recent parliamentary elections in France. Traders have added a political risk premium to euro-zone assets, leading to elevated options prices over the next month. The euro's volatility curve has seen a significant shift, with one-month volatility rising to almost 6% from 5%. This indicates that currency traders are now considering the possibility of EUR/USD declining to as low as 1.0580, compared to 1.0606 on Friday.

Upcoming US inflation data and the Federal Reserve's dot plot will also influence the euro's short-term trajectory. Fed fund futures currently price in 36 basis points of Fed loosening this year. A dovish dot plot from the Fed, indicating the possibility of two rate cuts, could shift futures pricing and impact the euro, although the adjustment is expected to be modest. Beyond the French elections, the euro's performance will continue to be influenced predominantly by the dollar-side of the equation. Last week's non-farm payrolls data showed that the US economy remains robust, which could keep the euro under pressure.

ECB Easing Prospects

The outcome of the European parliamentary elections has made the prospect of another interest rate cut in the euro zone even more unlikely. French President Emmanuel Macron's call for a snap legislative ballot has added political uncertainty to the euro, which is expected to persist for over a month. A weaker euro could exacerbate inflation in the euro zone, which has been rising recently.

Austria's central bank governor, Robert Holzmann, expressed concerns about the euro's weakness even before the election results. He noted that if the Federal Reserve is unable to implement three rate cuts this year as outlined in its dot plot, it would impact the exchange rate and inflation. With euro zone headline and core inflation closer to 3% than 2%, and the European Central Bank (ECB) acknowledging that price pressures will remain elevated through this year and next, the case for a second rate reduction is weak.

Friday's US jobs data, which showed stronger-than-expected payroll expansion, further complicates the ECB's position. If the Fed is unable to deliver the anticipated rate cuts, many ECB governing council members may resist any decision that would widen the policy rate differential in favor of dollar-denominated assets.