By Mike Dolan
LONDON (Reuters) – Sterling’s return close to pre-Brexit referendum levels against the euro owes much to Britain’s delicate dance between resetting relations with Europe and the return of “Trumpism” in the United States.
A services-heavy British economy should weather trade tariffs threatened by U.S. President-elect Donald Trump better than an already hobbled euro zone. And repairing rifts with latter, still the UK’s biggest trading partner, holds out some hope of re-attracting investment flows from the European Union.
A big question going forward is whether newfound currency strength muddies any improved export picture and puts the spotlight back on the Bank of England’s foot-dragging on lowering interest rates.
But since the Labour Party returned to government after the UK elections in July, the pound has mostly moved higher against the euro and on a broad trade-weighted basis against world currencies.
Indeed, the latter already returned to pre-Brexit levels in anticipation of July’s vote.
This week, just as Finance Minister Rachel Reeves made a largely symbolic visit to the euro group finance ministers’ meeting in Brussels, the pound surged again to within a whisker of its 2022 peak versus the euro. A move beyond this would take it back to where it sat before 2016’s fateful vote to leave the EU.
Symbolism aside, basic interest rate machinations were the immediate driver. The European Central Bank cut borrowing costs once again on Thursday and signalled more to come, while the Bank of England is set to stand pat at its final meeting of the year next week.
Assuming it holds the line, the BoE’s main policy rate would stand higher above ECB equivalents than at any stage since the global banking crash in 2007. And further out in the borrowing spectrum, the gap between 10-year UK and German government bond yields is now at its widest point in two years.
Underlying those rate gaps, however, are multiple moving parts.
MID-ATLANTIC BALANCING ACT
Britain’s biggest bank, HSBC, recently lifted its sterling forecast and now sees it ploughing through 2022’s peak by early next year and on to 0.80 per euro, which would be the strongest level in eight years. That would add another 3 percentage points to its 5% gains on the euro for the year to date.
The HSBC strategists considered not only the widening rate gap with the euro zone but also how both the pound and the British economy will navigate the unfolding EU-UK “reset” as well as Trump’s promised universal import tariffs.
They reckon there’s only marginal direct benefits from the “rapprochement” between London and Brussels so far, plans that include tweaks to bilateral programmes, regular annual bilateral summits and Prime Minister Keir Starmer’s attendance at an EU leaders gathering in February.
But they concluded that global security and trade threats are pushing the two closer together.
That shift could boost the hampered investment flows from the EU to the UK and offset bilateral trade gaps, they said, noting the EU accounted for some 28% of all foreign direct investment to the UK in the decade to 2020.
But as the Brexit uncertainty and related political upheavals of the past decade now ebb – and currency volatility subsides as a result – relative economic performance should now re-assert its influence on the pound.
On that score, the euro bloc looks more exposed to winds ahead.
A mix of political logjams in Berlin and Paris and the euro zone’s outsized exposure to potential U.S. goods import tariffs darkens the immediate outlook there more than it does for Britain and the widening rate gaps reflect some of that already.
The HSBC team points out that goods account for just 42% of total UK exports but some 65% for the euro zone. Moreover, Britain is the world’s second-biggest services exporter and more than a quarter of those head to a U.S. economy that is still expected to grow briskly through next year.
The BoE’s 4.75% policy rate remains the highest of the G7 economies, including the United States. But UK rates are likely to fall faster than U.S. equivalents in 2025, though not by as much as the already far lower ECB rates.
That leaves the pound somewhere over the mid-Atlantic, potentially gaining on the euro while falling back against a buoyant dollar.
The stronger pound could create its own headwinds for an economy desperate to boost growth while raising taxes at home. But some relief against the dollar may well take the pressure off on that score.
For Britain to get the best of both worlds may be much harder in practice – but currency markets seem to be giving it some benefit of the doubt in sailing between the two right now.
The opinions expressed here are those of the author, a columnist for Reuters.
(By Mike Dolan X: @reutersMikeD; Editing by Jamie Freed)
