Euro to Pound Exchange Rate May be in the Hands of Referendum Hopes and Fears

Central bank impotence and a potential bottom in the euro mean that most of the volatility for EUR/GBP will likely be supplied by referendum speculation.

Recent efforts by central banks, especially the European Central Bank (ECB) and the Bank of Japan, to weaken their exchange rates have failed according to a report by HSBC.

They argue negative central bank deposit rates are failing to have any impact on exchange rates.

Negative deposit rates are used by central banks to dissuade banks in the real economy to park their money with them, as this then incurs a cost.

Their aim is to incentivise banks to lend to the wider economy. A secondary aim is the depreciation of the currency.

The European Central Bank, Bank of Japan, Swiss National Bank and Swedish Riksbank are all using negative interest rate policies.

The HSBC report, points out, however, that in none of those cases have negative rates managed to depreciate the country’s currency.

This goes for the euro, the yen, the Franc, and the kronor - but here we are most interested in the euro, which has failed to depreciate despite the ECB’s decision to cut deposit rates to -0.4%.

ECB Running Out of Policy Tools

HSBC do not just argue that negative rates have essentially failed, but also that the ECB is running out of policy options and this is creating a level of uncertainty which is contributing to a risk-off default backdrop:

“The fear of policy impotence is growing, in other words the idea that central bankers and governments cannot be relied upon to rescue the global economy and financial markets. The foray into negative rates and its fleeting negative impact on currencies have reinforced this fear. The resultant growing fear factor has, in turn, fostered a “risk off” mood in other markets.”

The negative sentiment caused by below-zero rates is having the unintended consequence of increasing demand for safe-haven currencies, which include the yen and the euro – the very currencies the policy was intended to weaken.

“In this way, cuts into negative territory by the ECB and BoJ are not only failing to generate EUR and JPY weakness, they may be contributing to their strength.”

Euro May Have Limited Downside Potential

HSBC’s assertion that neither the ECB nor the BOJ have the tools to effectively manage their exchange rate echo’s a theory propounded by Societe General’s Alvin Tan, who said the same thing in a note before the ECB’s March meeting:

“The indirect attempts to weaken the exchange rate through asset purchases and negative rates appear to be hitting the proverbial brick wall. Neither the trade weighted euro nor yen has depreciated over the past twelve months, despite escalating unconventional monetary policies.”

Tan argues the euro has limited scope for further down-side:

“Further easing is expected from the ECB this week but it is unlikely to push the EUR/USD exchange rate lower durably. We do not expect EUR/USD to break below the 1.04/1.05 low reached in 2015 over the course of this year, short of a Brexit scenario.”

The fact that the ECB seems unable to weaken its currency because of a negative feedback loop, which means heightened risk aversion actually supports the currency, diminishes the downside potential for the currency substantially.

GBP More Volatile

The pound’s renewed bout of weakness on Tuesday, goes to show what volatile times sterling is living through at the moment.

The most recent decline was caused by a poll, commissioned by the Telegraph, which showed the ‘leave’ vote in the lead with 49% and the ‘stay’ vote with only 47%.

These were amongst voters, regardless of whether they expected to vote or not.

Amongst those who were certain they would vote, the division was even wider, with euro-sceptics winning 52% versus the pro-EU 45%.

The poll renewed concerns about the possibility of Brexit after those fears had stabilized somewhat following the governor of the Bank of England Mark Carney’s mildly pro-EU stance at the recent parliamentary committee for Brexit, where he said getting out of the EU would carry economic costs, and that membership had provided wealth and prosperity to the UK.

The news that Bookies were favouring odds of a vote to stay winning, and several bank analysts had put the probability of staying at over 60%, had seemed to represent a wider feeling that the euro-sceptic campaign was losing steam, however, the recent ORB poll for the Telegraph, seems to have swung the pendulum back again, with the possibility that the Brexit campaign might be gathering momentum once more.

Putting it all together - Where Now for EUR/GBP?

According to the analysis above, the limited downside scope for the EUR combined with sterling’s volatility means the driving force behind the pair is likely to be Brexit hopes and fears.

In such a closely fought campaign, with no clear winner yet, investors and traders will be scrutinizing the trend of polls and trying to identify a winner emerging.

If they are unable to and polls continue to impart limited information about which way the country will vote, the pound is likely to move in a limited zone, until the referendum decides the victor.

At that point extreme volatility in the pound is likely whichever side wins.

As such until June, it is unlikely the EUR/GBP pair will see very much more volatility unless voters polarize on one side before the actual data of the referendum.

Charts Mildly Bullish in Very Short-Term

From a technical perspective Tuesday’s move higher has leant the chart a marginally more bullish bias.

The pair was forming a small head and shoulders topping pattern on the daily chart as annotated on the chart below.

This had bearish connotations, with a break lower expected, however, the break higher circled on Tuesday, has probably cancelled the pattern’s bearish potential, and a covering rally higher is now more likely.

Ideally the exchange rate would need to break clearly above the 0.7928 highs for confirmation of further upside, with a target at the R1 monthly pivot – a robust resistance level – at 0.7983.

The weekly chart offers little sign of where the pair might move next. 

EUR/GBP had built an inverted head and shoulders reversal pattern at the lows, made up of a trough (the left shoulder) followed by a recovery, then another lower trough (the head) followed by a recovery and the a final low (right shoulder) before the exchange rate finally broke clearly higher, and achieved the pattern’s minimum target at 0.7830.

The current sideways consolidation appears to be extending further sideways after sterling weakness today brought the rate back into the middle of the range.

The charts like the fundamentals offer no significant clues as to future movement and the possibility of a lengthening of the sideways consolidtion remains a strong possibility, particularly in the run up to the June 23 referendum.

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