Medium Term Eurozone Review

Discussion and Analysis by Charles Porter:

Mid-April saw the beginning of a consistent and predictable bear (downward) trend in the value of the Pound Sterling with respect to the Euro (GBPEUR). Up until the start of September, the Pound lost, on average, 2.14 percent each month. This staggering trend would have seen Sterling fall to a value of parity against the Euro as soon as December; one Pound would equal one Euro. However, largely down to Bank of England action, the seemingly relentless bear trend abated, allowing the Pound to arguably find a new support. Following a Bank of England policy change a couple of weeks ago, Sterling has entered into a comparable, if not more severe, downward spiral that would threaten to achieve parity by February. While markets may try, this doom and gloom appears overplayed.

In a bout of combined Euro strength and Sterling weakness, there was a sustained and rapid devaluation of the Pound-Euro currency cross. At the same time as the Euro made a significant correction against the US Dollar, the Sterling-Euro exchange rate was on course for parity by Christmas. Much to the relief of those liquid in the UK market, the trend abated, reversing the fortunes of Sterling currency markets.

At least the concretisation of this trend was achieved through central bank action. In the minutes released alongside the Bank of England’s monetary policy decision on 14^th September 2017 was one crucial paragraph that changed Sterling’s short-medium run outlook. Paragraph 30 of 38 explicitly stated that the interest rate was likely to go up at a faster rate than the market-priced yield curve was suggesting.

The importance of monetary policy to the international system is hard to understate. In a world of leveraged financial markets and indebted sovereigns, the rate of interest, the primary instrument of monetary policy, has significant impact. The rate of interest has twofold significance. Used to manipulate the macroeconomy, the interest rate mechanism determines both the cost of borrowing and the reward for saving.

At the individual level of personal savings, the effect may seem insignificant. However, when aggregated, for example to the volume of a large pension fund, the rate of interest in nominal terms becomes inconceivably large. Moreover, the rate of interest, as suggested above, will impact sovereigns starkly.

The sovereign bond market is highly sensitive to the underlying rate of interest and determines the rate of return that sovereigns, governments, will pay upon its stock of debt and newly issued bonds. Therefore, the rate of interest has systemic importance.

The response within currency markets that we see to the rate of interest is primarily down to the reward effect. A higher rate of interest will encourage money into the domestic economy and the domestic currency because investors and traders will receive a higher rate of return. When monetary policy continues to be threatened by the zero-lower bound, there is an additional confidence effect to beginning to normalise interest rates.

In addition to this support, price analysis could reveal that a new price floor has been created with the Pound Sterling appearing to trade within a medium term horizontal band against the Euro. However, there is also a significant probability that we are trading within a downward orientated channel.

From the trend that commenced around the turn of November, there are moments where the best fit curve, or OLS regression, will demonstrate a severely downward facing trend. From the start of November until the mid-November, the average market trend would dictate that by mid-February, the exchange rate between the Pound and the Euro would fall to parity; one Pound = one Euro.

Before you get terrified, pull your money out of UK markets or never travel abroad again, the trend by no means dictates that his will happen. There will be Sterling support and Euro resistance levels that would be expected to dissuade the Pound from falling too close to this level. However, a test of this level is definitely not out of the question.

The past few weeks especially have taught us that politics matters. Arguably making the significance of economics and economic data fall towards zero, the tumult within the UK government and Brexit negotiations has been able to stun the Pound.

Overwhelmingly, the deviation of the Pound Sterling from its pre-September bearish trend is highly positive for the future of the Pound. Without this, the risk of a test of parity would have continued to be significant. The management of the Brexit negotiation process will be the primary determinant of the value of the Pound, particularly as we approach mid-December and the verdict for second phase progression. A considerable number of positive expectations currently surround the Brexit process following Tusk’s optimism and praise of the Florence speech. These expectations are already priced into the currency cross. Disappointing these expectations could be disastrous for the Pound.

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