Euro-pound parity looks remote, but so does a big rally
When a euro was worth as much as 93 pence during the summer, two things dawned on investors: the euro-sterling exchange rate was heading for parity and the currency pair was the best proxy for evaluating Brexit.
In which case, the market view now is that Brexit risk for the UK is abating. Since that nadir for the pound following a 10 per cent fall over the summer, the UK currency has since clawed back 6 per cent against the single currency.
The idea of parity now seems far fetched, with the euro’s value having dropped back to 88p. And while that still represents an 11 per cent decline in euro-sterling from the levels before the 2016 referendum, the investor mood is cautiously optimistic about sterling.
Sterling is “one of the most mispriced G10 currencies, and sentiment is still way too bearish on the UK [economy]”, says Stephen Jen of Eurizon SLJ Capital. “In fact, I would not be surprised if, a year from now, the pound turns out to be the best-performing currency [based on risk-return ratios] in the world.”
Is such confidence justified? While much depends on Brexit negotiations, there is an argument that investors are turning their attention elsewhere. With the European Central Bank and the Bank of England both meeting on Thursday, it tempting to take a breather from the Brexit cut-and-thrust and focus on economic fundamentals.
Investors will need to put this theory to the test the next time a significant piece of Brexit news arises. Euro-sterling trading is likely to experience “long periods of boredom punctuated by moments of sheer terror”, says Jeremy Cook, economist at World First.
Others sense a shift. Marianna Georgakopoulou, multi-asset strategist at Ashburton Investments, thinks that over time sterling and the euro will become “desensitised” to Brexit.
There is enough Brexit risk premium baked into sterling, she says. “It is very possible that we will see at certain times Brexit drivers taking a back seat and fundamentals driving the currency,” adds Ms Georgakopoulou.
Among those drivers will be the UK and eurozone growth performances and inflation, she says, and in both instances they point to sterling gaining further ground on the euro. Lofty expectations for eurozone growth may be hard to meet, while UK inflation may be starting to normalise, despite last month’s tick-up in CPI to 3.1 per cent.
Much depends on monetary policy. Investors are on the lookout for signs of the ECB speeding up the pace at which it puts its loose policy strategy into reverse. For the Bank of England, the focus remains one of gauging what the progress of Brexit talks and a likely transition deal means for the UK economy.
In the case of the former, Jefferies economists expect ECB president Mario Draghi to reveal “as little as possible” this week. Any sign of Brexit talks progressing “should provide the BoE with more confidence to continue normalising policy and encourage a stronger pound”, says MUFG currency analyst Lee Hardman.
Politics, however, will never be very far from investors’ thoughts, in part because the central banks will tread carefully. The BoE is in no rush to raise rates again, says Rabobank’s Jane Foley, so politics is set to stay “in the driving seat” for determining the euro-sterling rate for the time being.
It may do so because Brexit proves more complex than the market foresees. “We still have a high risk of a hard Brexit,” according to Silvia Dall’Angelo, senior economist at Hermes Investment Management. “There is a sense that the second phase of negotiations will be way harder than the first.”
Nor should the market discount the return of political risk in Europe. Marine Le Pen’s defeat in the French presidential election was a significant contributor to the euro’s 2017 rally, but investors risk ignoring the electoral trends on the continent, according to Bank of Montreal’s Stephen Gallo.
“You have a swing to the right,” he says. “You have a very fractured situation politically and that came out in the German election result.”
Next year’s Italian election, expected to be in March, and the outcome of German coalition talks will be “a big deal”, he says.
Mr Gallo is one of a clutch of analysts expecting a modest appreciation in sterling’s value against the euro. ING thinks the 85p level could be tested in the first quarter should the Italian election put the euro under pressure and a transition deal generate a positive reassessment of the UK economic outlook.
“With a range of indicators suggesting that the UK economy is at a standstill, a reduction in medium-term uncertainty may rekindle some of the ‘animal spirits’ among consumers and firms — and see more cash put back to work over the coming year,” says ING’s Viraj Patel.
All that may yet be swallowed up by a distinctive ECB shift towards monetary tightening. The consensus forecasts is for the currency pair to stay broadly on an even keel through 2018, according to Reuters.
It may not amount to much, but after 18 months of Brexit-induced volatility, that may represent something of a win for the pound, and breathing space for the Bank of England.
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