Sterling’s Resurgence: A Balancing Act Between Europe and the US
Sterling’s recent rise against the euro, nearing pre-Brexit referendum levels, reflects a complex interplay of factors, primarily Britain’s evolving relationship with the European Union and the resurgence of "Trumpism" in the United States. The UK’s service-oriented economy is perceived as more resilient to potential trade tariffs threatened by the US President-elect compared to the eurozone, which is already facing economic challenges. Simultaneously, improving relations with the EU, still Britain’s largest trading partner, offers a glimmer of hope for attracting renewed investment flows from the bloc. This delicate balancing act between transatlantic relations and European reconciliation has created a unique dynamic for the pound.
The pound’s strengthening trajectory raises crucial questions about its impact on the UK’s export prospects and the Bank of England’s monetary policy. While a stronger currency can hinder exports, it can also mitigate inflationary pressures. The Bank of England’s reluctance to lower interest rates further adds to the complexity. Since the Labour Party’s return to power in July, sterling has generally appreciated against both the euro and on a trade-weighted basis against global currencies. The latter had already recovered to pre-Brexit levels in anticipation of the July election, signaling market confidence in the new government. This week, coinciding with Finance Minister Rachel Reeves’ symbolic visit to the Eurogroup meeting in Brussels, the pound surged again, approaching its 2022 peak against the euro, a level last seen before the 2016 Brexit referendum.
While the symbolic significance of this milestone is undeniable, the immediate driver of the pound’s surge was interest rate differentials. The European Central Bank’s recent interest rate cut and indication of further easing, contrasted with the Bank of England’s expected hold on rates at its upcoming meeting, have widened the gap between UK and eurozone interest rates. This difference has become the most pronounced since the 2007 global financial crisis. Moreover, the spread between 10-year UK and German government bond yields has reached its widest point in two years, further underscoring the divergence in monetary policy.
Navigating a Complex Global Landscape: The UK’s Mid-Atlantic Balancing Act
Underlying these rate gaps are several interconnected factors, including Britain’s evolving relationship with the EU and the potential impact of US trade policies. HSBC, Britain’s largest bank, recently upgraded its sterling forecast, predicting it will surpass its 2022 peak early next year and reach 0.80 per euro, the strongest level in eight years. This would represent an additional 3% gain on top of its 5% appreciation against the euro so far this year. HSBC’s analysis considers the widening rate gap with the eurozone, as well as how the pound and the British economy will navigate the EU-UK "reset" and the potential impact of universal import tariffs promised by the incoming US administration.
HSBC’s strategists see limited direct benefits from the initial stages of the UK-EU rapprochement. However, they believe that global security and trade threats are fostering closer cooperation between London and Brussels, potentially boosting investment flows from the EU to the UK and offsetting bilateral trade imbalances. The EU accounted for approximately 28% of all foreign direct investment into the UK in the decade leading up to 2020. As Brexit-related uncertainty and political volatility subside, and currency fluctuations diminish, relative economic performance will likely become a more dominant influence on the pound. In this regard, the eurozone appears more vulnerable to upcoming challenges.
Political gridlock in Berlin and Paris, coupled with the eurozone’s greater exposure to potential US import tariffs, clouds the region’s near-term outlook more than Britain’s. The widening interest rate differentials reflect this perceived vulnerability. HSBC’s analysis highlights that goods constitute only 42% of total UK exports, compared to 65% for the eurozone. Furthermore, Britain is the world’s second-largest services exporter, with over a quarter of those services destined for the US, an economy still projected to grow robustly next year.
The Pound’s Trajectory: Navigating Uncertain Waters
The Bank of England’s 4.75% policy rate remains the highest among G7 economies, including the US. While UK rates are expected to decline faster than their US counterparts in 2025, they are not predicted to fall as much as the already significantly lower ECB rates. This places the pound in a unique position, potentially gaining against the euro while depreciating against a strengthening dollar. A stronger pound could create headwinds for the UK economy, which is striving to boost growth amidst domestic tax increases. However, some relief against the dollar might alleviate some of this pressure, allowing the UK to navigate a precarious balance between two major economic powers.
Achieving the ideal scenario of benefiting from both a strong euro and a weak dollar might be challenging in practice. However, currency markets currently seem to grant the UK some leeway as it navigates this complex transatlantic dynamic. The pound’s recent resurgence suggests that despite the ongoing uncertainties, the market recognizes the UK’s potential to leverage its unique position in the global economy. The coming months will be crucial in determining whether this delicate balancing act can be sustained, and whether the pound can maintain its upward trajectory against the backdrop of a rapidly changing global landscape.
