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Pound Sterling Rallies against Euro Amidst Fading ECB Hike Expectations and Surging Gas Prices

  • EU gas prices in fresh surge
  • Raises stagflation prospects
  • Forcing down ECB hike expectations
  • Weighing on the EUR

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The Euro has come under pressure against Pound Sterling, the Dollar and other currencies as surging gas prices threaten to trip the Eurozone economy into recession later in 2022, in turn limiting the European Central Bank's ability to raise interest rates.

Money markets now predict less than 80 basis points of European Central Bank (ECB) rate hikes by year-end, compared to 95 bps at the start of the week, as fears of Eurozone stagflation rise.

The repricing was triggered by another spike in European gas prices, the result of Russia's decision to squeeze gas supplies to Europe this week in retaliation for sanctions.

The fading rate hike expectations mechanically adjusted Euro exchange rates lower and foreign exchange strategists are now seriously considering the prospect of the Euro falling to parity against the Dollar.

"The appearance of hawkish ECB rhetoric in the middle of last month raised the possibility of a rate hike as soon as July. That said, the benefit to the EUR from a hawkish ECB many be short-lived if investors are simultaneously concerned about recession risks in the Eurozone," says Jane Foley, Senior FX Strategist at Rabobank.

The Euro-Dollar rate dipped a sizeable 1.26% to trade in the 1.0350s, its lowest levels in five years. 

The Pound capitalised on the Euro's selloff and recovered recent losses caused by the lowering of Bank of England (BoE) interest rate hike expectations. The Pound to Euro exchange rate rallied back above 0.88% to trade in the 1.1750s.

BoE rate hike expectations fell in the wake of the May monetary policy update where they raised near-term inflation forecasts but slashed growth and long-term inflation forecasts.

Pound Sterling Live reported at the time the Bank of England could be the first major central bank to spell out the difficult reality facing developed economies in which growth falls and inflation surges and that what happened to the Pound could happen to other currencies in the near-future.

Fast forward one week and the realisation that the Eurozone economy faces a difficult few months has dawned on the Euro.

"The Bank of England has recently predicted a long period of stagflation for the UK. Many thought the British central bankers were pessimists as a result. I think yesterday’s price moves illustrate that the BoE’s view will soon become the majority view amongst market participants, and not just regarding the UK!" says Ulrich Leuchtmann, Head of FX and Commodity Research at Commerzbank.


Russia Weaponises Gas Supplies

The trigger for the recalibration in ECB rate hike expectations - and by extension the weaker Euro - appears to be another spike in Eurozone gas prices after supplies from Russia were curtailed midweek.

Natural gas prices soared in Europe on Thursday on news Russia was sanctioning energy companies, specifically a key Polish pipeline that could squeeze supplies to Europe further.

Russia sanctioned EuRoPol GAZ SA, the owner of the Polish part of the Yamal-Europe gas pipeline.

Russia also sanctioned units of Gazprom Germania and dozens of other companies based in countries that have imposed sanctions on Russia in response to its invasion of Ukraine.

31 companies were listed on May 11 by the Russian government and they are now banned from conducting transactions and entering Russian ports. Meanwhile gas transit to Europe via Ukraine has been severely curtailed with the national operator saying it can no longer control its pipeline in Russian occupied territories.

"The news in Europe of gas supply disruptions first through Ukraine and then to Germany triggered a further deterioration in growth expectations in Europe," says Derek Halpenny, Head of Research, Global Markets EMEA at MUFG.

Gas prices surged and markets were trading deep in the red, with Germany's DAX down more than 2.0%.

EU has a significant fuel trade deficit

Above: The EU is particularly reliant on external fuel sources. Image: Source: Macrobond, Bank J. Safra Sarasin, 09.05.2022.

The Euro to Dollar exchange rate slumped 0.75% to trade at 1.0436 and some analysts are of the view a fall to parity could be on the cards if energy supplies are curtailed further.

"The bottom line is that we can't accurately price the risk of a disruption to Europe's gas supplies, but if it happened, the risk of EUR/USD breaking parity would be substantial, and that keeps the natural urge to start building a long-term position in euros at bay," says Kit Juckes, FX Strategist at Société Générale.

The Pound to Euro exchange rate shot higher as Sterling recouped losses in tandem with the EUR/USD slump. (Set your FX rate alert here).

Fundamentally, investors could also realise the UK is not necessarily in a materially worse position than the Eurozone in the inflation and growth stakes.

Amundi EU gas source

Image: Eurostat

Indeed, while the Bank of England looks certain to deliver further rate hikes the market is of the view the European Central Bank will bottle a chance to normalise rates.

The UK's gas dynamics also appear to be in a stronger position than that of the Eurozone given the UK's ability to process Liquified Natural Gas coming off ships into gas, before sending it via pipeline to Europe.

We note reports that day ahead UK gas prices had plummeted earlier in the week amidst a glut of LNG-sourced gas awaiting to be exported to Europe.

"Natural gas prices jumped as a result and while prices jumped in the UK as well, prices have been more depressed in the UK of late. Since the start of April, prices in Europe are down 10% but over the same period prices in the UK are down 40%," says MUFG's Halpenny.


EUR/USD Parity Could Lift Sterling Further

Analysts warn the Euro could be in for further weakness were Russia to further squeeze European gas supplies, an outcome that is increasingly likely given an abject failure by Russian forces to make progress in eastern Ukraine.

The war is dragging on and Russian President Vladimir Putin has little to show for his efforts apart from a hollowed out army.

Desperation could see Russia lash out against the West and one area of strength remains Russia's dominance over European gas supplies.

A further tightening of gas supplies would materially impact the Eurozone's growth outlook and sour sentiment towards the Euro further.

Analysts are watching out for a test of the psychologically significant 1.0 level in EUR/USD, a break of which could offer more downside and potentially offer support to the GBP/EUR exchange rate.

"Whether or not USD strength means that EUR/USD will move to parity in the coming months, remains to some extent dependent on the fundamental backdrop in the Eurozone and on EU policy," says Jane Foley, Senior FX Strategist at Rabobank.

"In our view the war in Ukraine has tied the outlook for the EUR very closely to that of EU energy security," she adds.

Rabobank tell clients they now see a strong chance of a recession in the Eurozone towards the end of this year.

"How heavily the EUR trades in the coming months is likely to be a function of how big the risks to growth in the region develop," says Foley.

Should the EUR/USD continue falling but the GBP/USD remains relatively supported then the GBP/EUR exchange rate would automatically push higher.