Euro to pound forecast to fall to 0.72 by year end, say DNB Bank SA

The pound's solid fundamentals will shine through by the end of the year end, leading some analysts to forecast a fall to 0.72 versus the euro.

The pound has untapped potential according to the Norwegian Bank DNB SA.

In recent note they argue the currency will appreciate as it becomes increasingly clear that the Bank of England (BOE) will raise interest rates.

This will strengthen sterling as higher interest rates will increase the inflow of foreign capital seeking higher rates of return within the UK:

“We think the market is under-pricing the timing and pace of Bank of England rate hikes. We expect the central bank to start hiking in November.”

DNB see the UK's robust labour market and the recent wage increases recorded in January as marking the start of an up-trend in inflation expectations.

The pound will start clawing back its losses before the autumn on the back of positive rate hike rhetoric:

“Leading up to this we expect to see interest rate expectations pick up and a stronger GBP leading up to this.”

BOE rate rises will be gradual as the strengthening pound puts downward pressure on inflation, by cutting the price of foreign imports, and the headwind will slow down the pace of cuts.

Brexit fears are also forecast to have a “dampening effect” on sterling – so the real price growth will probably mostly come after the June 23rd referendum, as indicated by their forecasts.

Exchange Rate Predictions

DNB forecast EUR/GBP to rise to 0.77 in one month, 0.76 in three months and then fall to 0.72 in 12 months’ time. The exchange rate is currently at 0.7583.

The graphic above provides a visual of the bank's forecast (maroon line, entitled "DNB"), compared to the forward rate (peacock blue line “Fwd”), which is the rate a commercial bank is willing to commit to exchange euros for pounds at some specified date in the future.

The light blue line entitled CF Mar 16 refers to the ‘consensus’ forecast – which an average of many different analysts’ forecasts.

The dark blue line entitled PPP refers to the Purchasing Power Parity (PPP), which is a way of calculating the ‘true’ value of one currency against another. PPP is calculated by finding the exchange rate at which a basket of goods priced in euros is exactly equal to an identical basket of goods in pounds.

The PPP rate and Forward rates are both above the current exchange rate suggesting fair value lies above today’s rate and therefore that the currency should drift higher, but DNB expect the opposite.

What to Watch?

The two main events to watch in the week ahead are UK inflation data on Tuesday 22, which is forecast to come out at 0.4% from 0.3% previously, but could surprise to the upside (aided by recent gains in oil).

This would support the pound as it would indicate the BOE might raise interest rates sooner than markets currently expect. 

And any headlines concerning Brexit, or referendum polls if they show wild swings, although they also argue that polls were not very useful at predicting the Scottish election so should be taken with a ‘pinch of salt’.

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