GBP/EUR going lower says Danske BankAs BoE strikes a dour tone on the outlookBut City Index analyst sees potential gainsWarns of a scenario where 1.11 is tested again

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The Pound will likely fall following Thursday's crucial Bank of England interest rate decision and forecast update say analysts who are looking for a replay of the previous such Monetary Policy Report, held in August.

The decision, which comes alongside the release of the quarterly Monetary Policy Report (MPR), forms the highlight of the week for the Pound but it could also set the tone for the UK currency into year-end.

"In our base case of a 75bp hike, we expect EUR/GBP to move slightly higher on the announcement," says Kirstine Kundby-Nielsen, an analyst at Danske Bank.

Market pricing shows investors are prepared for a 50 basis point hike on Thursday as the Bank continues to bring inflation under control.

However, the expected deflationary fiscal policies to be introduced by new Prime Minister Rishi Sunak and Chancellor Jeremy Hunt could lessen the need for such a strong response by the Bank.

As such, expectations for a 50 basis point hike cannot be discounted and markets have raised bets for such an outcome over recent days.

There is the possibility that Sterling declines in the wake of such a surprise.

"Don't rule out a smaller UK rate hike to 2.75% from 2.25% as pressure to tighten rates more aggressively may have diminished in the wake of the UK’s leadership change. A 50 bp rate hike by the BOE would tend to be pound-negative," says Joe Manimbo, Senior Market Analyst at Convera.

But the actual size of the rate hike is only part of the story: the UK currency will potentially take greater and more enduring signals from the tone set by the Bank and the state of the economic forecasts it releases.

Reactions to previous Monetary Policy Reports - particularly that of August - suggest Thursday's decision could set in place a more enduring trend that sees out 2022.

"As we expect the BoE to highlight the gloomy growth outlook for the UK economy amid rising recession risk, we expect EUR/GBP to continue its move higher during the press conference," says Kundby-Nielsen.

The Pound rallied by 1.88% against the Euro in October, taking the Euro-Pound exchange rate to 0.86 from a high of 0.8866.

For those watching from the other side of the equation, the Pound-Euro exchange rate rallied to a high of 1.1630 from a low of 1.1280 during the past month.

If Danske Bank's expectations are proven correct November would likely see a shift in fortunes for Sterling against its European counterpart.

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Danske Bank expects the Pound to be undermined by the Bank's trademark caution regarding the outlook that would suggest the Monetary Policy Committee remains reluctant to deliver as many hikes as the market is expecting.

Current market pricing shows investors are looking for a further 140 basis points of hikes from the Bank in 2022, more than any other central bank.

"The BoE tends to err on the side of caution, we expect a return to smaller increment hikes," says Kundby-Nielsen.

Danske Bank expects another 50bp hike in December followed by a final 25bp hike in February 2023, which is fewer hikes than priced in markets, a development that underscores an expectation for Pound weakness.

However, another analyst is more constructive on Sterling's prospects against the Euro.

Fawad Razaqzada, Market Analyst at City Index, says GBP/EUR is now not too far off testing key resistance and the 200-day average around the 1.1765 handle.

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"It will likely get there if the BoE opts for 75bps," says Razaqzada, adding it could rise even further if the Bank does not make it clear that this will be a one-off 75bp hike.

"A dovish surprise of a 50-bps hike, on the other hand, could initially lead to a drop in the pound, but if this is accompanied with a stronger hawkish message in terms of future hikes then we could see a quick rebound," he adds.

However, Razaqzada cautions the day could be a volatile one for the pound.

"The vote split, the BoE’s language, as well as growth and inflation forecasts, will all have a say in how the currency will react. Generally, the more hawkish the BoE is compared to expectations, the more upside should be expected in the immediate response. The opposite is also true," he explains.

As an example, if the Bank says that the committee feels several forceful rate increases are warranted to bring inflation down, this will be quite hawkish says Razaqzada.

"In contrast, if the BoE signals greater worry over economic growth than inflation, then this will imply a reduction in future rate hikes and a lower terminal rate, and thus lead to a negative response in the pound," he adds.

The City Index analyst says any weakness in Sterling resulting from the event could see Pound-Euro break through key short-term support located around 1.1468; a potential break below this level could trigger a fresh wave of technical selling towards the 1.11s "in the days and weeks to come," says Razaqzada.