Pound Eyes Post-Brexit High as ECB Takes Centre Stage

Sterling continues to climb above the €1.21 threshold against the euro. For weeks, we’ve anticipated further gains, buoyed by the pair establishing solid support above €1.20 since the start of the month. Attention now turns to the European Central Bank (ECB), expected to announce a 25-basis-point rate cut today. Updated economic forecasts are likely to underscore a worsening outlook, potentially exerting additional pressure on the euro.

Since the 2016 Brexit referendum, GBP/EUR has spent 85% of the time trading within a €1.11–€1.20 range, and less than 1% above €1.21—a level over one standard deviation above the post-referendum average. Will the pair revert to this long-standing pattern, or is it transitioning into a higher trading range as it looks set to end the year above €1.20 for the first time since 2015? For now, the momentum appears favourable. Political stability in the UK, coupled with moderate fiscal stimulus, starkly contrasts with the economic challenges on the continent. This comparatively positive economic outlook also supports expectations that the Bank of England (BoE) will pursue a policy trajectory closer to the Federal Reserve than the ECB, enhancing sterling’s yield advantage over the euro.

Consequently, a re-test of the 2022 high near €1.22 seems plausible. However, while this might appeal to UK importers dealing in euros, hedging costs remain steep, with one-year GBP/EUR rate differentials standing at -200bps. A more dovish stance from the BoE could ease this, although such a move would likely also weigh on the GBP/EUR exchange rate.

A Spotlight on Tariffs

Looking ahead to 2025, a key concern is the potential escalation of the global trade war, likely to be triggered by the imposition of new tariffs under US President-elect Donald Trump. Global trade does not operate in isolation, as demonstrated during the initial US-China trade war in 2017. While the share of US imports from China declined over the following five years, the overall reliance on global supply chains persisted, with trade flows shifting to nations such as Vietnam, Mexico, Canada, and Eurozone countries.

The impact of these tariffs will depend on four key factors: the implementation timeline, the magnitude of the tariffs, the specific tariff structure, and the retaliatory measures adopted by other nations. For now, even the most pessimistic forecasts suggest limited effects on growth or inflation in 2024, with most of the economic repercussions expected in 2026.

Shifting to developments this week but remaining on the subject of tariffs, China made headlines yesterday. According to reports from Reuters, Beijing may allow the yuan to depreciate in 2025 to counteract higher tariffs under Trump’s renewed presidency. This announcement triggered declines in emerging market currencies and equities, while the dollar gained, offering insight into what may unfold next year. Meanwhile, US inflation rose from 2.6% to 2.7%, as anticipated. Core inflation increased by 30 basis points for the fourth consecutive month, which, while not ideal for the Federal Reserve, is unlikely to prevent a 25-basis-point rate cut next week. However, January could see a pause in further rate adjustments. The dollar rallied for a fourth consecutive session, with EUR/USD slipping below $1.05 once again.

Bank of Canada Signals Smaller Moves Ahead

The Bank of Canada (BoC) reduced its policy interest rate by 50 basis points for the second consecutive time. While this was largely anticipated, Governor Tiff Macklem’s unexpectedly hawkish comments about transitioning to more gradual cuts gave the Canadian dollar a boost.

The BoC has already slashed rates by 175bps this year—more than any other G10 central bank. However, following yesterday’s significant cut, expectations for further reductions have moderated, with only an additional 60bps anticipated by mid-2025. The gap between US and Canadian two-year yields narrowed, pulling USD/CAD back from its highest level in over four years. Despite this, the pair remains approximately 7% higher year-to-date, marking its best performance since 2018.

With Canadian inflation at target, a struggling labour market, and disappointing economic growth, further rate reductions are justified but are likely to proceed more cautiously. Of greater significance could be Trump’s tariff threats against Canada. Although such measures may not take effect until 2026, the risk sentiment they generate could weigh heavily on cyclical currencies like the Canadian dollar.

US SME Optimism Surges to 44-Year High

The US dollar rose for a third consecutive day as sentiment among small businesses turned positive, according to the first data release since Donald Trump’s election victory. Investors are now awaiting significant Treasury auctions over the next two days, alongside the crucial inflation report due later today.

Trump has long been viewed by investors as favourable to small and medium-sized enterprises (SMEs) in the United States. This perception has been evident throughout 2023 and 2024, during which the small-cap equity index Russell 2000 closely mirrored Trump’s rising election odds. One particularly well-received initiative was the 20% business tax deduction introduced during his first term. The sharp rise in SME sentiment following his re-election suggests smaller firms are prepared to overlook planned tariff increases and are instead focusing on the promised reduction of bureaucracy and deregulation initiatives. While actual sales figures remained unchanged in November, the outlook for general business conditions over the next six months soared to a record high, as per the NFIB survey published this week.

Attention now turns to the Consumer Price Index (CPI) report later today. Economists anticipate another strong monthly increase of 0.3% for November, matching October’s gain. The annual core inflation rate is expected to remain steady at 3.3%, while headline inflation may edge higher from 2.6% to 2.7%. Investors are likely to scrutinise the data closely, even though market volatility has declined markedly since 5 November—more so than is typical following presidential elections.

Pound Reaches Strongest Level Against Euro Since 2022

The pound has outperformed its G10 counterparts for much of 2024, buoyed by a UK economy that has proven more resilient than expected and expectations that the Bank of England (BoE) will adopt a cautious stance on cutting interest rates. This contrasts starkly with Europe, where economic growth has been lacklustre and the European Central Bank (ECB) has maintained a dovish policy. Consequently, GBP/EUR has climbed above €1.21, its highest level since March 2022.

The divergence between the BoE and ECB is expected to persist through 2025. Markets currently price in just three rate cuts by the BoE compared to six for the ECB. As a result, the yield spread between UK and German bonds has widened from 120 basis points to over 220 basis points in just a few months. Simply put, the pound offers a more attractive yield than the euro. Adding to the euro’s challenges are European political uncertainties, while the UK’s goods trade deficit with the US renders it less vulnerable to Trump’s tariff policies than the Eurozone.

Canadian Dollar Weakens Ahead of BoC Decision

The Canadian dollar fell to a four-and-a-half-year low against the US dollar yesterday, ahead of today’s Bank of Canada (BoC) policy decision. While a 25 basis point rate cut is fully priced in, 80% of swap traders now anticipate a larger 50 basis point reduction.

Last week’s disappointing Canadian employment data tilted expectations further in favour of a 50bp cut. This has driven USD/CAD up by over 1%, briefly surpassing the C$1.42 mark—its weakest level since April 2020. Widening rate differentials between Canada and G10 peers such as the US and UK have also contributed to this decline, with both the US dollar and particularly sterling on track to post their largest yearly gains against the Canadian dollar since 2015. Additionally, Canada’s sizeable trade surplus has placed it in the crosshairs of Donald Trump, whose tariff threats are weighing on both the Canadian dollar and the broader economic outlook.

While risks to the Canadian dollar remain tilted to the downside, a relief rally could materialise if policymakers adopt a less dovish stance than expected. In such a scenario, a pullback towards the C$1.40 level could occur. However, a move higher towards C$1.45 appears unlikely unless Canada faces significant tariff impositions from Trump in 2025.

Risk-On, Risk-Off

Currency traders have raised the likelihood of a Federal Reserve (Fed) interest rate cut this month to 86%, following Friday’s mixed US employment report. The next major data point will be November's US inflation figures, due on Wednesday, as Fed officials observe a blackout period ahead of the central bank’s meeting a week tomorrow. The US dollar has edged lower alongside Treasury yields, though geopolitical tensions are tempering its decline, as markets fluctuate between risk-on and risk-off sentiment amid developments in China.

Despite the dollar’s recent loss of momentum—having fallen nearly 2% since its November peak—driven by growing expectations of future Fed rate cuts, it remains a favoured safe haven during periods of heightened geopolitical uncertainty. While China’s most significant monetary easing in over a decade has supported risk assets, its intensifying trade conflict with the US has curbed broader risk appetite. China recently announced it would cut off key drone supplies to the US and Europe, which have been instrumental in Ukraine’s defence against Russia. This escalation in geopolitical risks, alongside tariffs and protectionist policies, is likely to keep currency market volatility elevated. Still, attention also remains on macroeconomic and monetary policy trends.

Although the US dollar and short-term Treasury yields have diverged somewhat since the US elections, their positive correlation remains unusually strong. This dynamic could spell trouble for the dollar if falling yields continue to fuel rate-cut expectations over the coming year.

Additional Stimulus from China

The euro has climbed well above the $1.05 level, recovering from its yearly low near $1.0330 reached at the end of November. European developments continue to weigh on the currency, with political uncertainty and disappointing macroeconomic data presenting challenges.

The euro’s rebound can largely be attributed to shifts in US markets, where a peak in surprise economic data, lower bond yields, and a moderation in Fed expectations have prompted a repricing of the dollar. This adjustment has benefited the EUR/USD exchange rate.

A potential driver for further recovery lies in China. Beijing has pledged to bolster economic growth in 2025 through increased fiscal stimulus and a moderately loose monetary policy. These measures aim to offset the negative effects of heightened US tariffs. Investors are optimistic about further supportive announcements during the Central Economic Work Conference on Wednesday. While Chinese equities surged by approximately 3%, the rally in European assets lost momentum during Monday’s session.

Key Resistance for Sterling

The pound strengthened at the start of the week, moving in tandem with other risk-sensitive currencies following China’s shift towards a looser monetary policy. Sterling shook off weak UK labour market data and gained from improved global risk sentiment, with GBP/USD nearing $1.28 and GBP/EUR approaching €1.21.

UK labour market surveys revealed the fastest decline in job vacancies since August 2020, as businesses face the dual pressures of rising employee costs and a subdued economic outlook. Business confidence, according to BDO, has fallen to its lowest level in nearly two years. The slowing jobs market, combined with a larger pool of candidates, could ease wage pressures, which would be welcomed by the Bank of England (BoE). However, it may also lead to a more dovish monetary stance for 2025 than markets currently anticipate, potentially weighing on the pound.

Sterling remains supported by relatively high yields compared to most of its G10 peers, but any dovish reassessment of BoE policy could weaken the currency. The 200-day moving average for GBP/USD, currently at $1.2819, acted as a resistance point during Friday’s bounce following the US jobs report. A break above this level would be a key technical milestone, potentially paving the way for further gains in the pound and pushing GBP/EUR past €1.21.

GBP starts the week with a positive outlook against the EUR, supported by political uncertainties in the Eurozone and expectations that the Bank of England (BoE) will implement fewer interest rate cuts than the European Central Bank (ECB). The GBP/EUR exchange rate remains near 2024 highs, with technical indicators pointing to further upside. Trading above key moving averages and with a rising Relative Strength Index (RSI), the pair could test the 1.2090 resistance level, with potential for further gains if Thursday’s ECB decision signals a dovish stance.

The ECB meeting is this week’s main event, with markets largely anticipating a 25 basis point rate cut, though a deeper 50 basis point cut could weaken the Euro further. Should the ECB opt for caution, the Euro might find some support, tempering GBP/EUR gains. As a result, the tone of the ECB’s messaging will play a key role in determining the pair’s direction, particularly as it approaches its two-year high at 1.2103.

Domestic factors also weigh heavily on the Pound, with UK GDP data on Friday expected to show a 0.1% contraction for October. A deeper decline could pressure Sterling, while a stronger-than-expected reading might bolster it. Consumer sentiment, via the GfK index, will also be scrutinised for signs of deterioration post-budget, adding another layer of influence to GBP performance.

Looking ahead, next week’s UK inflation and labour market data will be pivotal for BoE policy expectations. Against the USD, GBP has held near 1.28 as signs of cooling in U.S. labour market momentum emerge. However, with the prospect of fewer Federal Reserve rate cuts in 2025, the Dollar could remain supported, capping GBP/USD gains. Overall, the Pound has room for near-term strength, but outcomes hinge on key data and central bank decisions this week.