By Mike Dolan
LONDON (Reuters) – Sterling’s return to pre-Brexit referendum levels against the euro is largely down to Britain’s delicate dance between resetting relations with Europe and returning to ‘Trumpism’ in the United States.
A services-oriented British economy could weather the trade tariffs threatened by newly elected US President Donald Trump better than an already stumbling eurozone. And mending differences with the latter, still Britain’s biggest trading partner, offers some hope of re-attracting investment flows from the European Union.
A big question going forward is whether the currency’s newfound strength clouds an improved export picture and puts the spotlight back on the Bank of England’s dragging policy in cutting interest rates.
But since the Labor Party returned to government after July’s British election, the pound has largely risen against the euro and on a broad, trade-weighted basis against world currencies.
The latter have already returned to pre-Brexit levels ahead of the July vote.
This week, just as Chancellor of the Exchequer Rachel Reeves made a largely symbolic visit to the Eurogroup finance ministers meeting in Brussels, the pound rose again to within a stone’s throw of its 2022 peak against the euro. A step beyond this would return the country to where it was before the ill-fated 2016 vote to leave the EU.
Apart from the symbolism, base rate machinations were the immediate cause. The European Central Bank cut borrowing costs again on Thursday and signaled more to come, while the Bank of England will remain at its final meeting of the year next week.
Assuming this trend continues, the BoE’s key policy rate would be higher above ECB equivalents than at any time since the 2007 global banking crisis. And further down the lending spectrum, the difference between ten-year UK and German ten-year rates government bonds have become smaller. now at its widest point in two years.
However, there are several moving parts underlying these interest rate differentials.
MID-ATLANTIC BALANCING ACT
Britain’s largest bank, HSBC, recently upgraded its forecast for sterling and now sees the currency plowing through the 2022 peak early next year to a rate of 0.80 per euro, which would strongest level in eight years. That would add another 3 percentage points to the euro’s 5% gain so far.
HSBC strategists were concerned not only with the widening interest rate differential with the Eurozone, but also with how both the pound and the British economy will navigate the unfolding “reset” between the EU and Britain, as well as about Trump’s promised universal import tariffs.
They believe that the ‘rapprochement’ between London and Brussels has so far delivered only marginal direct benefits, plans that include adjustments to bilateral programmes, regular annual bilateral summits and the presence of Prime Minister Keir Starmer at a meeting of EU leaders in February.
But they concluded that global security and trade threats are bringing the two closer together.
This shift could boost stymied investment flows from the EU to the UK and offset bilateral trade gaps, they said, noting that the EU accounted for around 28% of all foreign direct investment in the UK in the decade to 2020 .
But as the Brexit uncertainty and associated political upheavals of the past decade have subsided – and the currency’s volatility is declining as a result – relative economic performance should reaffirm its influence on the pound.
In that respect, the euro bloc seems more exposed to the coming winds.
A mix of political problems in Berlin and Paris and the eurozone’s excessive exposure to possible tariffs on US goods cloud the immediate outlook there more than for Britain, and widening interest rate differentials already reflect some of that.
The HSBC team points out that goods make up just 42% of total UK exports, but around 65% of the eurozone. Moreover, Britain is the world’s second-largest exporter of services, with more than a quarter of that going to a US economy that is still expected to grow strongly next year.
The BoE’s policy rate of 4.75% remains the highest among the G7 economies, including the United States. But UK rates are likely to fall faster than US rates in 2025, but not as much as the already much lower ECB rates.
That leaves the pound somewhere above the mid-Atlantic, where it has the potential to gain against the euro, while falling against a booming 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 could take the pressure off that score.
It may be much harder for Britain to get the best of both worlds in practice, but the currency markets appear to be giving the country some benefit of the doubt at the moment by navigating between the two.
The opinions expressed here are those of the author, a columnist for Reuters.
(By Mike Dolan
