Sterling recovery hinges on how soft Brexit proves to be

A key development in foreign exchange markets in the past month has been that the euro has broken out of the relatively narrow trading range of $1.04-$1.16 against the dollar that it had occupied since early 2015.

The euro made impressive gains against the dollar in the first half of the year, climbing from $1.04 to above the $1.14 level, despite further rate hikes by the Federal Reserve in March and June.

The euro’s rally gained further momentum in recent weeks, as it climbed to near $1.19, its highest level since January 2015.

Developments in Europe have helped the euro to gain ground. Eurozone growth has picked up appreciably in the last three quarters, with the jobless rate moving steadily lower.

This has seen the ECB row back on its easing bias, in particular dropping references that it could lower rates further.

Markets now expect three-month money rates in the eurozone to turn positive by autumn 2019, compared to mid-2021 last year. There is also a growing expectation in markets that the ECB will wind down its monthly asset purchases or quantitative easing (QE), next year.

Abating political risks have also helped the euro, with far-right and euro-sceptic parties not doing particularly well in European elections this year, most notably in France.

By contrast, political risks have risen elsewhere, most notably in the US and the UK.

The dollar is not the only currency against which the euro has been gaining ground. The snap UK general election, which saw the Conservative Party lose its majority in Parliament, has seen renewed pressure put on sterling. So also has uncertainty around Brexit.

As a result, the euro has been on a steady upward path against the UK currency over the last three months, climbing from 84p to 91p.

Sterling found support at this level last autumn when the pound fell sharply on concerns that the UK could be faced with a hard Brexit.

It is important that support holds at around the 91p level for sterling as if it is breached, it could open up a move to 94-95p for the euro, levels that it previously reached back in 2009.

The negotiations between the UK and EU on Brexit are likely to be the key factor influencing sterling in the months ahead.

Markets have been disappointed with the lack of progress in the early stages of the negotiations. However, the UK Government is due to publish a number of position papers on Brexit-related topics which might help advance the process.

There are hopes that the outcome of the talks will be a soft Brexit, with transition arrangements agreed that allow for continuing free trade between the UK and EU until a full trade deal is negotiated.

Nonetheless, there is still a risk of a hard Brexit where the UK loses free access to EU markets and has to fall back on World Trade Organisation rules.

This would be very negative for the British economy and would see further falls in sterling.

A hard Brexit could see the euro move well above the 91p level, with some commentators talking about the possibility of parity for the euro.

On the other hand, a soft Brexit should see the UK currency regain much of the ground lost since June 2016, with the euro moving down towards 80p.

Markets will be keeping a very close eye on the Brexit negotiations in the months ahead to see if a deal is likely to be done.

If progress is made on the Brexit talks and the negotiations move on to discussing trade later this year or in early 2018, then sterling could begin to recover ground on hopes that a deal for a soft Brexit can be agreed.


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