PoundSterlingLIVE - Pound Sterling recovered earlier losses against the Euro after market participants sniffed a European Central Bank interest rate cut on the horizon.
The central bank raised interest rates to record highs on Thursday but said this was likely the final increase and it now intends to maintain current levels in an extended pause.
The tenth hike of the cycle was accompanied by a downgrade to growth forecasts but higher inflation forecasts for 2023 and 2024 and a commitment to keep an eye on the data when considering whether or not to raise interest rates again.
"The key ECB interest rates have reached levels that, maintained for a sufficiently long duration, will make a substantial contribution to the timely return of inflation to the target," said the ECB in a statement.
Despite a commitment to keeping interest rates at current levels for a "sufficient" time, market pricing for rate cuts in 2024 has been lifted, prompting Eurozone bond yields to fall which took the Euro lower alongside.
"Despite that it clearly states rates are needed at a high enough level for a long enough period, it immediately sparked market speculation about the timing of a first rate cut. German Bunds strengthened following today’s decision as a result, even as it wasn’t fully priced in. Yields lose between 1.6-6.7 bps with the belly of the curve outperforming. The euro slips," says Mathias Van der Jeugt, an analyst at KBC Capital Markets.
The GBP/EUR exchange rate recovered from lows near 1.1607 to 1.1639, the Euro to Dollar rate fell from 1.0729 to 1.0655.
"We maintain our forecast that the ECB will start cutting rates as soon as April 2024, sooner than currently expected by the markets," says Nerijus Maciulis, an analyst at Swedbank.
The prospect of interest rate cuts will become more likely if the Eurozone economy slows further. Maciulis notes PMIs and leading indicators currently pointing to continued weakness in demand, which will significantly reduce business pricing power and may even lead to shrinking profit margins.
"Monetary policy will become increasingly more restrictive through two channels – real rates will continue climbing rapidly as inflation recedes, while credit conditions will be restrictive and credit impulse will remain negative," says Maciulis.
Currencies have tended to fall once their respective central banks have sent an unambiguous signal that they have reached a peak in the hiking cycle, prompting investors to grow confident enough to bring forward the timing of a rate cut.
A clear example is the New Zealand Dollar which has underperformed peers since the Reserve Bank of New Zealand sent a clear signal it was hitting the pause button on its hiking cycle, despite having been amongst the first and most aggressive hikers.
The U.S. Federal Reserve, on the other hand, has paused its hiking cycle but maintained guidance that it stands ready to hike again, thus keeping rate cut expectations at bay.
The ECB appears to have leaned towards the RBNZ model, which could prompt further weakness in the Eurozone's currency.
But the Pound will unlikely get too far as the Bank of England decision is due next week.
The Bank has proven a reluctant hiker for much of the current cycle which analysts say can explain much of 2022's underperformance in Pound Sterling.
Bank of England Governor Andrew Bailey has already signalled the peak in interest rates might be close and this suggests next week will see the Bank deliver a 'dovish' message.
If the Euro's experience is anything to go by, this could result in a weaker Pound.
An original version of this article can be viewed at Pound Sterling Live