The key to understanding FX moves is to have a firm grasp of monetary policy as communicated by central banks. The EURGBP is being pressured lower by GBP strength at the time of writing. The GBP Is strengthening on rising inflation pressures revealed in this week’s data but whether it can continue remains to be seen. Eventually, the GBP may start to find sellers stepping in on stagflation fears. At the moment, buyers are dominating on the expectations that the Bank of England will need to hike interest rates more aggressively. However, after a certain point, higher interest rates not only deal with inflation but can also crush growth. Here is the narrative explained below.

Stretched GBP longs

The GBP is showing a very stretched positioning to the long side on the COT report. Why has the GBP been bought so strongly? Partly, it was due to the GBP being heavily sold on Brexit fears, but mainly due to the rising inflation pressures resulting in higher interest rates from the UK.

So, the first thing to note is that GBP longs are at an extreme. The significance of this is that GBP buying has been ongoing and is now vulnerable to a correction on GBP negative news.

The GBP’s driver

High inflation in the UK has been leading to higher interest rate expectations from the Bank of England which has continued this last week. On Tuesday this week, UK Average earnings rose above maximum expectations to 7.8% vs 7.5% y/y prior. Average earnings in the UK are now outpacing inflation. Remember, that strong labour data is inflationary and these strong wage prints are an inflationary force. Then on Wednesday, we had the UK inflation print. The core reading was 6.9% y/y above the 6.8% expected and the headline was in line with expectations at 6.8%. Still three times above the Bank of England’s target.

These inflationary prints have kept the GBP bought against EUR and have increased expectations for a terminal rate of 6% for the Bank of England.

Can EURGBP falls continue?

The risk for the EURGBP is that there is a sharp snap higher. The most likely catalyst for that could be either, or a combination of the following two options. Firstly, deflationary pressures emerge in the UK. So, if the labour market weakens, or growth rapidly slows then the Bank of England will be less likely to hike rates and will moderate its pace. Secondly, an improving outlook for Europe and/or more inflationary pressures, that will put more pressure on the ECB to hike rates, could also lift the EURGBP. At the time of writing, the EURGBP is set around the 100EMA on the weekly chart. If that breaks lower, there is heavy support for the air in the 0.8400/0.83000 region marked below.