Pound-to-Euro Exchange Rate Eyes Three-Year High Amid Interest Rate Dynamics

The Pound-to-Euro exchange rate is on track to reach a fresh three-year high in the coming months, supported by elevated UK interest rates. However, the pace of this ascent may be gradual as investor bets on further rate cuts in the Eurozone cool.

Overnight indexed swaps, which reflect market expectations for central bank interest rates, now indicate just two more rate cuts from the Bank of England in 2024—down from four anticipated just weeks ago. This repricing has strengthened the Pound, pushing GBP/EUR from January lows of 1.18 to 1.2090 by midweek.

Recent UK economic data has reinforced the Bank of England’s cautious stance, with inflation unexpectedly rising to 3.0%, surpassing forecasts of 2.8%. The central bank had previously signalled a preference for cutting rates quarterly, but money markets now suggest that pace may be too aggressive given persistent inflationary pressures. Some economists even predict UK inflation could reach 4.0%, driven by rising fuel prices, goods costs, and the government's upcoming tax and minimum wage hikes.

Whether GBP/EUR can push further toward 1.22 will also depend on the European Central Bank’s (ECB) rate decisions. If the ECB slows or pauses its rate-cutting cycle, the narrowing interest rate differential between the UK and Eurozone could limit the Pound’s upside. ECB board member Isabel Schnabel recently suggested the central bank might hold off on further cuts, raising uncertainty over the Euro’s trajectory.

The ECB has already lowered rates five times since June in response to sluggish Eurozone growth, but renewed inflation concerns and geopolitical risks, such as trade tensions, could alter its course. Currently, the ECB’s key rate stands at 2.75%, down from 4% in September 2023, with markets pricing in at least two more cuts this year. However, if expectations for a third cut diminish, Euro rates could adjust more hawkishly than UK rates, potentially slowing GBP/EUR gains.

Euro in Trump’s Grip as US Policy Shift Reshapes European Outlook

The euro remains heavily influenced by US President Donald Trump, whose daily remarks continue to drive sentiment and movement in the common currency. Trump has reportedly pressured Ukrainian President Zelenskiy to make peace with Russia swiftly or risk losing US support entirely. By sidelining Kyiv and Brussels in negotiations, the US is signaling a significant shift in diplomacy, leaving Europe’s geopolitical future uncertain.

This development overshadowed hawkish remarks from ECB Board Member Isabel Schnabel, who urged caution on rate cuts amid growing inflation concerns and tariff threats. German bond yields responded, with the 10-year Bund climbing to a three-week high of 2.55%.

Today's market focus will turn to three scheduled Federal Reserve speakers, US jobless claims, the Philly Fed Index, and European consumer confidence data. For EUR/USD to attempt a retest of $1.05 this week, it will need to maintain support above $1.04.

UK Inflation Surges, but Pound Holds Steady Above $1.26

Fresh data this morning showed UK inflation rising faster than expected in January, but despite the jump, the pound remains resilient above $1.26 against the US dollar. GBP/EUR, however, has slipped from a near one-month high of €1.21, as Bank of England (BoE) Governor Andrew Bailey downplayed the risk of renewed price pressures in comments yesterday.

The headline Consumer Price Index (CPI) climbed to 3% in January from 2.5% in December, surpassing the 2.8% forecast and reaching its highest level in ten months. The increase was driven by rising food prices, airfare costs, and the introduction of value-added tax on private school fees. Core CPI also jumped to 3.8% from 3.2%, while services inflation—a key metric for the BoE—rose to 5%, slightly below economist expectations and the BoE’s own 5.2% projection. The pound remains directionless as a result, though short-term gilt yields have pushed higher. Meanwhile, market pricing still suggests just two BoE rate cuts this year.

The BoE anticipates inflation will reach 3.7% by Q3 due to rising energy costs, while private sector wage growth has also surged to 6.2% in the three months to December. This could warrant a cautious approach to rate cuts. However, with domestic economic weakness and signs of a cooling labour market, the current pricing of just two cuts may prove too conservative—we see room for three before year-end.

Euro Slips as US Yields Rise Despite German Confidence Boost

The euro declined for a second consecutive day, retreating from last week’s near three-month high against the US dollar. Despite a sharp rise in German investor confidence, EUR/USD slid back toward the lower $1.04 range, weighed down by stronger US Treasury yields that bolstered the dollar.

Germany’s ZEW Economic Sentiment Index surged to 26 in February, its highest level since July 2024 and well above expectations of 20. The 15.7-point jump—the largest since early 2023—was fuelled by hopes that the upcoming German election would pass without major disruptions and that private consumption would rebound in the coming months. On the geopolitical front, President Donald Trump’s decision to postpone tariffs provided a lift to Germany’s benchmark equity index, which hit record highs. Meanwhile, optimism surrounding a potential US-brokered peace deal in Ukraine has supported market sentiment, though Trump’s concessions have raised concerns among European and Ukrainian officials.

In the bond market, European yields continued to climb as traders weighed the implications of increased defence spending and higher bond issuance across the Eurozone. However, details on fiscal plans are expected only after Germany’s election this weekend. While rate differentials currently favour the dollar, the euro’s downside may be limited if confidence grows that fiscal stimulus could support economic growth and reduce the need for aggressive rate cuts from the European Central Bank. Moreover, EUR/USD appears undervalued relative to inflation-adjusted interest rate spreads, suggesting potential support in the near term.

Dollar Strengthens as Treasury Yields Climb and Fed Stays Cautious

The US dollar index rebounded above 107 on Tuesday, snapping a three-day losing streak as the 10-year US Treasury yield pushed past 4.5%. This shift came after Federal Reserve officials signalled a cautious stance, suggesting they are in no hurry to cut interest rates while inflation remains a concern. Investors are now focused on the release of last month’s Fed meeting minutes for further clarity on monetary policy.

Economic data releases were sparse this week ahead of Friday’s flash PMI reports, but Tuesday brought an unexpected boost. The New York Empire State Manufacturing Index surged by 18.3 points in February, reflecting strength in the sector. However, inflationary pressures remained evident, with input costs accelerating at their fastest pace in nearly two years and selling prices also on the rise. These developments led to a slight reduction in market expectations for Fed rate cuts, pushing Treasury yields higher and lifting the dollar against all major currencies.

On the geopolitical front, US and Russian officials held their first high-level discussions on the Ukraine war since its early days, notably without Ukraine’s participation. European leaders remain side-lined as broader security implications unfold. With no breakthrough in sight and uncertainty surrounding a potential Putin-Trump summit, market sentiment has turned cautious, further reinforcing support for the dollar.

Sterling Rises on Strong Wage Growth, but Upside May Be Limited

Sterling is trading near a two-month high against the US dollar after UK jobs data revealed a sharper-than-expected rise in wage growth, reaching an eight-month high. This has pushed 10-year gilt yields higher as markets reassess the Bank of England’s (BoE) ability to contain inflationary pressures.

The three-month average weekly earnings y/y increased to 6.0% in December, surpassing expectations of 5.9% and up from 5.6% in November. Pay growth, excluding bonuses, climbed for a third consecutive month, driven largely by the private sector (6.2%). The BoE closely monitors this metric, as persistent wage inflation contributes to sticky services inflation. After adjusting for inflation, real wages also saw a slight increase. Meanwhile, the unemployment rate remained at 4.4%, defying expectations of a rise to 4.5%, while job vacancies continued to decline at a slower pace. These figures are likely to reinforce the BoE’s cautious stance as it weighs persistent wage pressures against the UK’s sluggish economic growth and ongoing job market adjustments.

As a result, expectations for BoE rate cuts have been scaled back slightly. Against the euro, sterling has broken out of a narrow trading range and may look to extend gains beyond €1.21, particularly given Europe’s political uncertainties. However, against the US dollar, sterling appears overbought, and a correction may be likely. While the 100-day moving average at $1.2666 could be tested in the near term, further upside may be limited.

Euro's Rally Faces Resistance Amid Political and Economic Uncertainty

After posting its second-best week of the year, the euro’s rebound from near $1.01 to $1.05 against the US dollar appears to be losing steam. While EUR/USD has broken out of its descending trend channel, in place since last October, technical indicators suggest it is now overbought. Additionally, European equities started the week cautiously as tensions between the US and Europe over Ukraine and tariffs escalated.

European leaders convened an emergency meeting in Paris on Monday to discuss security concerns, raising fears of increased government borrowing to fund military expenditures. This drove Germany’s 10-year bond yield to a one-month high of 2.5%, as higher spending could fuel inflation and push yields higher. Meanwhile, US-Russia negotiations on Ukraine are set to begin on Tuesday, with a successful outcome potentially driving oil prices lower, which could provide some support to the euro. However, while ceasefire prospects have bolstered risk appetite and the euro, concerns over US isolationism and European security risks remain a headwind for the currency.

On the monetary policy front, the European Central Bank is expected to cut interest rates by 25 basis points at each of the next three meetings, with the deposit rate potentially falling below 2% by 2026. While this would typically weigh on the euro, rising US inflation could shift the real rate differential in favour of further EUR/USD gains.

However, given the uncertain macroeconomic landscape—alongside geopolitical and tariff-related risks—EUR/USD's upside potential may be capped for now. A stronger domestic outlook and weaker US economic data would be needed to push the pair toward $1.06. Investors will closely watch Germany’s ZEW sentiment surveys today, with expectations for the index to rise to a six-month high.

Tariff Delays and Peace Talks Lift Markets, Weigh on Dollar

The market continues to feel the positive effects of the recent postponement of tariffs on Mexico and Canada. Adding to the risk-on sentiment, reports surfaced that President Trump is actively working on a peace deal between Ukrainian President Zelensky and Russian President Putin. This optimism drove oil prices lower and overshadowed shifts in Federal Reserve expectations, putting additional pressure on the US dollar.

Meanwhile, last week’s inflation data had a mixed impact. The higher-than-expected CPI print was offset by a weaker PPI figure, leaving inflation as a net-neutral factor for markets. However, the sharply disappointing retail sales report just before the weekend further weakened the dollar, while equities extended their rally. As a result, the probability of a Fed rate hike this year fell from 9% to 3%. Market volatility remains high, with uncertainty persisting on both inflation and trade policy fronts.

British Pound Rides Risk Rally but Faces Key Data Tests

The British pound strengthened against safe-haven currencies last week, benefiting from easing trade tensions and renewed hopes for a Ukraine ceasefire, which sent oil prices tumbling. GBP/USD surged from around $1.23 to over $1.26, while GBP/JPY climbed more than 2% in a week. However, GBP/EUR remained relatively stable as geopolitical tailwinds also supported the euro.

Looking ahead, the impact of a potential Ukraine ceasefire could be mixed—if the deal raises security concerns for Europe, the war premium on the euro may stay low, capping further FX gains. Meanwhile, growing market focus on trade risks highlights the UK’s relative resilience to direct tariffs compared to the Eurozone, helping GBP/EUR hold above €1.20. Additionally, rate differentials continue to favour the pound, with last week’s UK GDP surprise leading traders to scale back expectations for BoE rate cuts.

Key economic data this week will test the pound’s strength. Employment figures on Tuesday, flash PMIs and retail sales on Friday, and inflation data on Wednesday will be closely watched. In particular, services inflation, which has remained stubbornly above 4% for nearly three years, is expected to jump back above 5%. The key question for UK rate markets remains whether to price in two or three BoE rate cuts for the rest of the year.

Euro Finds Respite Amid Trade and Geopolitical Shifts

The euro defied expectations last week, rallying against the dollar as geopolitical and trade developments turned unexpectedly supportive. EUR/USD briefly touched $1.05—only the second time this year—marking its strongest weekly performance in three weeks. Hopes for a peace treaty between Russia and Ukraine gained traction, partly due to President Trump’s diplomatic involvement. Meanwhile, fears of imminent US tariffs on European cars subsided, with reports suggesting a delay until at least April 2nd, aligning with the expected completion of a Department of Commerce review on reciprocal tariffs.

However, risks remain for the eurozone. President Trump has taken aim at value-added taxes (VAT), arguing they function as disguised tariffs that disadvantage US businesses. Given that VAT is a critical revenue source for the EU, the scope for negotiation is minimal, potentially setting the stage for renewed trade tensions.

While our expectation of a modest euro rebound has played out, supported by rising real rate differentials and a priced-in Fed pause, broader macro uncertainties and tariff risks could cap further gains. Without stronger domestic catalysts, EUR/USD may struggle to break past $1.06 in the near term.