GBP/EUR may be set to hold above 1.20Chart resistance at 1.2152 risks erosionECB policy decision may prompt setbackIf policy normalisation remains on tableBut Ukraine conflict underpins GBP/EUR

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The Pound to Euro exchange rate reached another post-EU referendum high on Monday when it hit 1.2190 and upside risks persist with the war in Ukraine and Thursday's European Central Bank (ECB) policy decision being the immediate near-term drivers.

Pound Sterling rose by 1.2% against the Euro last week in its strongest advance since November as mainland European currencies bore the brunt of the market response to Russia’s ongoing and increasingly destructive attempt to impose itself on Ukraine.

That response has entailed, among other things, significant increases in oil and gas prices that will act as an economic headwind and would mean more currency being sold on the market by net importers like Europe and the UK among others.

“While no statistical model can fully capture the impact of recent events, we can apply our existing tools to better understand the drivers of the FX moves,” says Zach Pandl, co-head of global foreign exchange strategy at Goldman Sachs.

“In our view this suggests that EUR/USD and EUR/GBP are the most appropriate crosses for new hedges for Ukraine-related risks (EUR/CHF has been highly responsive to these developments to date but intervention risk has likely risen now),” Pandl and colleagues said in a Friday note.

Above: Pound to Euro exchange rate shown at daily intervals.

Reference rates at publication:

GBP to EUR: 1.2150High street bank rates (indicative): 1.1826 - 1.1911Payment specialist rates (indicative): 1.2042 - 1.2090Find out more about specialist rates and service, hereSet up an exchange rate alert, hereSterling-Euro reached its highest since the immediate aftermath of the Brexit referendum last Friday before being halted around 1.2148, which coincides with technical resistance from the 61.8% Fibonacci retracement of 2016’s referendum-induced downtrend.

But that overhead barrier would risk erosion this week if wholesale energy prices remain ascendant and continue to weigh on the European single currency, which is widely understood to be more exposed to any supply disruptions from Russia and rising import bills.

“If Euro Area growth holds up reasonably well and the ECB remains on track to raise rates this year, we would still see a bullish structural outlook for the currency. For now we stay on the sidelines in EUR crosses while we await more clarity on the unfolding geopolitical crisis,” Pandl and colleagues also said.

While side effects of the increasingly destructive conflict in Ukraine and the resulting humanitarian crisis have been a heavy burden for the Euro thus far, the financial and economic implications are highly inflationary and could yet have implications for the ECB policy outlook that would potentially pose a headwind for Sterling this Thursday.

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“It looked almost certain that the ECB was preparing markets for an abrupt change in forward guidance coming at the March meeting. Markets started pricing for hikes this year, but the situation in Ukraine has changed the calculation,” says Neil Wilson, chief market analyst at Markets.com.

Financial markets had anticipated the ECB would cease buying European government bonds and lift its deposit rate from -0.5% to 0% this year before Russian military forces crossed into Ukraine, but have since marked down those expectations substantially; weighing on the Euro along the way.

That could have been a mistake, however, given inflation has risen further since the February meeting when the ECB had already pointedly acknowledged growing upside risks to the outlook for price pressures, which are set to remain on an upward trajectory due to the attack on Ukraine.

“We also think that the updated ECB economic projections can signal greater confidence about the positive inflation impact of the crisis than its negative economic impact. In turn, this can be construed by the markets as less dovish and thus can limit further EUR losses,” says Valentin Marinov, head of FX research at Credit Agricole CIB.

Above: Pound to Euro exchange rate shown at weekly intervals with Fibonacci retracements of referendum fall indicating likely areas of technical resistance for Sterling. Click image for closer inspection.

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If the inflationary impact of events in Ukraine leads the ECB’s Governing Council closer to concluding that its symmetric two percent target could be met sustainably without the need for “the accommodative impact of policy rates to be reinforced” by quantitative easing, then it would likely reignite and reinforce market expectations for an uplift in its interest rates later in 2022.

That would in turn potentially place a floor under the single currency and limit the Pound-to-Euro exchange rate by encouraging sentiments and speculative wagers such as the below.

“While the market continues to unpack the complexities and uncertainties of the rising geopolitical stress, we believe that it has ignored four critical macro drivers between EUR and GBP: growth, inflation, terminal rate pricing, and valuations,” says Mark McCormick, global head of FX strategy at TD Securities, writing in a Friday research briefing.

“Growth-wise, while the EZ has more direct Russian trade exposure, the UK has greater financial market links through banks and assets. On inflation, our factor points to higher EZ pressures, though it will require some ECB interest. Even so, we note the divergence between EURGBP and ECB/BOE terminal pricing, which has moved in favor of the EUR,” McCormick and colleagues said.

TD Securities suggested last week that clients of the bank sell Sterling at 1.2113 and buy the EUR/GBP exchange rate around 0.8255 as McCormick and colleagues anticipate a decline toward 1.1627 over the coming weeks.

They would walk away from the trade, however, if Sterling rises as far as 1.2468 rather than falling.