ECB vs BoE: What's next for EUR/GBP?The European Central Bank (ECB) and the Bank of England (BoE) both raised interest rates by 50 basis points at their final meetings of the year. The Eurozone's policy rate was hiked to 2.5%, the highest in fourteen years, and the UK's to 3.5%, the highest since late 2008.
In contrast to the relatively dovish BoE meeting, the ECB meeting was substantially more hawkish than the market had anticipated, prompting the EUR/GBP cross to surge.
In a divided vote, the BoE decided to raise rates by 50bps, with one member (Mann) pressing for 75bps and two members (Tenreyro and Dhingra) preferring to maintain current rates. According to the BoE statement, more increases in the Bank Rate may be necessary due to ongoing inflationary pressures fueled by a tight labour market. In the first quarter of 2023, UK CPI inflation is expected to fall as household spending and property market indicators weaken.
Even if the ECB lowered its speed of rate rises from 75bps to 50bps, it made it clear that interest rates will still have to climb consistently and by a steady pace to reach restrictive levels to get inflation back to 2% quickly.
The ECB also indicated that quantitative tightening will begin in March 2023. The ECB will not reinvest all expiring securities' principal payments in the Asset Purchase Programme (APP), meaning its asset portfolio of eurozone bonds will fall at an average pace of €15 billion per month until Q2 2023, with the subsequent rate established over time.
During the press conference, ECB President Lagarde reiterated that the ECB will rise with tenacity and that 50bps may be the right rate hike for the next meeting and the two after that. She also hinted that once the peak is achieved, "it won't be enough to hit and withdraw," and that high interest rates will be in place for a longer period of time.
Historically, the interest-rate gap between the Euro Area and the UK has been one of the key driver behind the EUR/GBP exchange rate.
Market reactions to the BoE and ECB meetings: Yields differential matter
Before today's meeting, the market was highly dovish on the ECB, pricing in a peak of 2.8% next year, while it had already built in hawkish expectations on the BoE, pricing in a peak of 4.6% in the Bank Rate in August 2023.
German bond yields soared by 15 basis points after the ECB rate announcement and during Lagarde's press conference, but UK gilt yields stayed nearly unchanged from pre-BoE meeting levels.
The negative yield spread between German and UK sovereign bonds shrank throughout the curve today as investors repriced ECB rise expectations. The 2-year German-UK yield gap narrowed to -1% and the 10-year one to -1.2%.
In the coming weeks/days, market expectations for the ECB rate may continue to rise as ECB hawks are likely to reiterate their aggressive stance. The Bank of England's market pricing may stay broadly stable, given it has already incorporated heightened expectations ahead to the meeting. This may indicate that the negative yield disparity between German and British bonds will continue to narrow, exerting upward pressure on the euro-pound exchange rate.
A further 30 basis point reduction in the negative yield spread between 2-year German bonds and UK gilts, lowering it from -1% to -0.70%, might drive EUR/GBP to 0.89 or near to the psychologically important level of 0.90.
