Defying many predictions, sterling has strengthened marginally against most of its trading peers in 2017, writes Conor Haugh.
Brexit induced uncertainty that was originally predicted to hurt the UK economy has so far been less pronounced than feared.
The notable exception to this was the euro which was helped by a booming eurozone economy and saw the pound weaken by 3% against its most significant trading partner.
In fact, the UK is lagging both Europe and the US in terms of growth, a trend which is expected to continue for the coming years.
The sharp depreciation of sterling in late 2016 has helped drive up UK inflation, and this increase led to a 25 basis point interest rate hike by the Bank of England in November, the first tightening move in over a decade.
Financial markets remain unconvinced that the highly-indebted UK economy can sustain much higher rates and current expectations are for the central bank to hike rates just once more, later this year.
The market outlook for sterling in the year ahead is more positive than 12 months ago.
Many forecasters view that the bad news is factored into the currency and the potential for a “no deal” outcome to the EU-UK Brexit talks has reduced of late.
The two key drivers of sterling in 2017, namely Bank of England policy and Brexit negotiations, will again play lead roles in 2018, albeit with the former likely to have less of an impact this year.
The stability of the pound should remove the upward pressure on inflation we saw in 2017, and with expectations of moderate inflation in the years ahead, the Bank of England has indicated that only two further hikes will be likely over the next two years.
As we get into our stride this year, the sizeable question of Brexit remains.
The lesson of last year is that developments can be both slow and unpredictable.
The formal Article 50 process for leaving the EU was triggered some nine months after the vote.
Discussions regarding the separation terms appeared difficult with little or no progress being made for long periods of time.
However, the final push in recent weeks which saw the Brexit divorce bill agreed, non-binding commitments made on citizens’ rights and the border, have been sufficient to allow discussions move to the second phase of negations on the transitional arrangements and the future of a UK-EU trade deal.
The outcome of the negotiations will be crucial to the performance of sterling. The UK government’s objective is for a transition period of around two years following a March 2019 exit.
Should this be agreed, it would give a boost to sterling, because a smooth and gradual transition is perceived to be a positive for the UK economy.
Given the slow pace of negotiations so far, it is expected that any progress will only become apparent later in the year.
This uncertainty should prevent any sustained recovery in sterling over much of 2018 amid bouts of volatility as news of progress on the major issues becomes available.
What are the main risks that could drive a move to parity?
The most likely driver is a negative outcome surrounding the Brexit negotiations.
Any development that increases the likelihood of the UK leaving the EU without a deal could see renewed pressure on the pound and the potential for parity to be triggered.
Furthermore, even if the two sides reach a provisional agreement on some of the issues, the mantra of “nothing is agreed until everything is agreed” espoused by both sides will ensure that market uncertainty will prevail until a final deal is signed, or not.
An alternative scenario is the performance of the euro.
The ECB beginning to reduce its accommodative policy sooner than the market currently expects could drive a move higher in European interest rates, further underpinning the single currency.
The influence of central bank monetary policy will continue to be a driver of foreign exchange markets but will likely be secondary to issues surrounding Brexit.
The Bank of England has repeatedly stressed that any further rate hikes will be limited and gradual, and the market agrees with this assessment out to a two-year time horizon.
Unless the economic outlook radically changes, central bank policy in the UK will remain in the passenger seat as regards the UK currency.
Sterling has been resilient last year as long periods of negotiation have been accompanied by tentative developments.
But until a clear outcome has been achieved, the risk of sterling underperformance remains.
Conor Haugh is head of growth at Bank of Ireland Global Markets.