The Pound Sterling to Euro (GBP/EUR) exchange rate fell to two-year lows in September as the Truss government’s tax cuts triggered panic selling of UK bonds.

Following the fiscal policy reversal, there was a quick recovery to highs around 1.17 before the exchange rate fell back to 1.13 as the Euro provided a broader recovery.

Consensus forecasts suggest little net change in 2023 as the UK and Eurozone economies face recession.

The ECB’s more hawkish stance is expected to support the Euro unless the sovereign debt crisis resumes, while weak UK fundamentals are expected to hold back the Pound.

Economic fears dominate – energy prices in focus

The economic outlook for both the UK and the Eurozone will raise further fears as both countries face the threat of recession due to soaring energy prices.

In this context, energy price trends will be a key element in 2023 given their importance to the UK and Eurozone economies.

Although the UK government has taken measures to curb energy prices at the retail level, there are still very significant price increases that will reduce consumer spending.

The UK economy is already facing a recession and if energy prices rise again, the pressure will intensify.

The EU will also remain very sensitive to changes in gas prices, with a significant deterioration in the terms of trade still important.

Danske Bank expects relatively narrow ranges to prevail, with the UK and the eurozone still struggling: “The cyclical outlook remains bleak for the UK economy, which is only exacerbated by tighter monetary policy, rising energy prices and higher inflation undermining purchasing power.”

Overall, Danske expects the UK outlook to be not radically different from the Eurozone, but energy prices will play an important role.

Danske added: “One factor to watch out for is the global energy crisis and in particular the supply situation for natural gas and electricity in Europe. If the supply situation eases, this would significantly improve the outlook for the eurozone economy and support the euro.”

The ECB’s hawkish stance should support the euro exchange rate

The ECB raised interest rates by 50 basis points to 2.50% at its December meeting, and the bank’s president Lagarde has said rates are likely to be raised to at least 3.50% in the first quarter of 2023.

TD Securities also expects a hawkish stance from the ECB. According to the bank: ‘We therefore have no doubt that policy will continue to tighten significantly over the coming meetings, with QT running in the background. The 50bp rate hike at the February and March meetings now seems a given and is likely to continue at the May meeting.”

The bank expects the final rate to be 3.75%.

Goldman Sachs commented, “In our view, the strongest signal was the Governing Council’s indication that rates should still ‘rise significantly at a sustained pace,’ which President Lagarde believes means a series of 50 basis point increases. This is a very different signal from a number of other central banks that have signaled that they believe the rate hike cycle is closer to completion.”

ING expects the ECB will want to strengthen the currency to help contain inflation.

To achieve this goal, it notes: “If the ECB is successful in boosting the euro, the euro will need to appreciate against those currencies that have a large weighting in the trade-weighted euro index. The US dollar (16%), CN (14%) and sterling (12%) have the highest weighting in this index.”

ING says: “Of these three currencies, we would say sterling is the most vulnerable given that the Bank of England (BoE) is closer to the end of its tightening cycle than the Fed and that the UK’s large current account deficit makes sterling vulnerable to a global slowdown.”

Pound outlook: Bank of England’s restraint, yield spreads set to narrow

Although the Bank of England has raised rates to 3.50%, markets expect the scope for further tightening to be limited after nine consecutive rate rises.

According to the latest survey of institutional investors, rates are expected to peak at 4.25%.

The ECB’s move away from negative interest rates will also have an important impact on capital flows. In particular, heavy investment flows out of the euro area are likely to reverse.

All other things being equal, this will support the euro and make it more difficult for the pound to rise against the single currency.

Commerzbank remains negative on the outlook for the pound: “If it becomes clear to the market that the Bank of England faces a more difficult task of maneuvering between inflation and recession than the ECB – which is what it looks like – meaning that it is easier for the ECB to continue its rate hike cycle, expect EUR/GBP to rise.”

Euro outlook: A repeat of the Eurozone debt crisis?

Rising yields will support the Euro, but there will also be potential negative effects on the economy.

There will also be concern about the risk of a new sovereign debt crisis as bond yields rise in countries such as Italy, Spain and Greece.

According to Goldman Sachs, “We have long believed that the ECB is limited in its ability to support the currency through more aggressive policy tightening, especially because QT in the eurozone means less support for sovereign credit, which is negative for the currency.”

Eurozone capital account strengthening

An end to negative interest rates in the eurozone should, however, lead to a marked repatriation of funds to the eurozone, which would support the euro.

MUFG notes: “At year-end, the euro is currently at the top of the G10 performance table – only the US dollar and Swiss franc outperformed the euro. This is not a bad performance given the war in Ukraine and the recession the eurozone is now likely to be in.”

The bank added: “We continue to see scope for EUR/GBP to rise with a possible more marked divergence in policy actions between the ECB and the Bank of England next year.

ING expects UK deficit stress: ‘In addition, a bad year for growth – and another challenging year for equity markets – suggests that the UK will need a cheaper exchange rate to attract investment. We will also see if the UK’s current account deficit of 6% of GDP can be reduced at all.”

Britain is coming back from the brink

Sunak was elected leader of the Conservatives in October and appointed prime minister in a much less febrile political atmosphere.

Rabobank notes that conditions have improved: “The political backdrop in the UK has certainly become calmer since Rishi Sunak took the reins of power. This was welcomed by investors after the disastrous premiership of Liz Truss and after Boris Johnson’s scandalous leadership.”

Underlying sentiment towards the UK is still very fragile, with near-term volatility linked to the housing sector.

According to TD Securities, “China’s reopening favors NZ over the UK, especially in the context of housing sector vulnerabilities.”

BMO Financial Group remains very cautious on the long-term outlook for the UK: ‘We would argue that overall the risk premium in the UK should be higher today than in the previous 10-year period.’

The bank added: “The UK economy and the British pound sterling still face numerous macroeconomic and balance of payments (BoP) factors.”

However, the company believes that many of the negative factors have already been priced in.

According to BMO, “the most aggressive phase of the price review seems to be disappearing in the rear view mirror,” adding that “one of the more attractive features of the UK macroeconomic picture is that it is usually advantageous to be the first through a crisis and come out the other side of it.”

Trade relations with the EU remain problematic

The UK government has moved away from a confrontational stance with the EU over the Northern Ireland protocol and Sunak has promised to negotiate, but there are still serious tensions and concerns over major trade issues.

Rabobank notes a more constructive political environment but remains cautious on UK fundamentals and notes: “However, Sunak’s low profile also means that there has been little new news recently on issues that have been hanging over the UK for months. These include progress on a settlement with the EU over the Northern Ireland protocol, which could help define the relationship between the UK and the EU over the coming years.”

The bank adds: “Added to this, the UK’s fundamental backdrop remains characterized by weak investment growth, low productivity levels and now recession.”

ING maintains its negative stance on GBP/EUR: “We continue to see the pound as vulnerable and expect EUR/GBP to creep towards 0.90 in the 6-9 month outlook.” (1.11 for GBP/EUR).