By Mike Dolan
LONDON (Reuters) – Sterling's return to pre-Brexit referendum levels against the euro is largely due to Britain's delicate dance between resetting relations with Europe and the return of “Trumpism” in the United States.
Britain's services-heavy economy should weather US President Donald Trump's threatened trade tariffs better than the euro zone already. And by mending faults with the latter, who are still the UK's largest trading partner, there is hope that investment flows will be withdrawn from the European Union.
A big question going forward is whether the strength of new currency cancels out any improved export picture and puts pressure back on the Bank of England's foot-dragging on interest rate cuts.
But since the Labor Party returned to government after the UK elections in July, the pound has mostly moved higher against the euro and on a broad basis with trade pressure against world currencies.
In fact, the latter has already returned to pre-Brexit levels in anticipation of the July vote.
This week, just as Finance Minister Rachel Reeves made a largely symbolic visit to the euro group finance ministers' meeting in Brussels, the pound rose again to within a whisker of its peak in 2022 against the euro. Any move beyond this would take him back to where he sat before the fateful vote in 2016 to leave the EU.
Symbolism aside, basic interest rate machines were the immediate leader. The European Central Bank cut borrowing costs again on Thursday and signaled more to come, while the Bank of England is set to hold its last meeting of the year next week.
Assuming it holds the line, the BoE's key policy rate would be higher than the ECB's equivalent rates than at any rate since the global banking crash of 2007. And further out in the lending zone , the gap between UK and German 10-year government bond yields. now at its widest in two years.
Underlying these rate gaps, however, are several moving parts.
MID-ATLANTIC LIFE ACT
Britain's biggest bank, HSBC, recently raised its excellent forecast and now sees it plowing through the 2022 top by early next year and on to 0.80 per euro, which would at its strongest in eight years. That would add another 3 percentage points to its 5% gains on the euro for the year to date.
HSBC strategists discussed not only the widening rate gap with the euro zone but also how both the pound and the British economy will manage the EU-UK “reset” to come in addition to Trump's promised universal import tariffs.
They believe that there are only marginal benefits from the “rapprochement” between London and Brussels so far, plans that include tweaks to bilateral programs, regular annual bilateral summits and Prime Minister Keir Starmer's attendance at the EU leaders' gathering in February.
But they concluded that global security and trade threats are pushing the two closer together.
The move could boost blocked investment flows from the EU to the UK and balance bilateral trade gaps, they said, noting that the EU accounted for around 28% of foreign direct investment into the UK in the decade to 2020.
But as Brexit uncertainty and the associated political upheaval of the past decade now recede – and currency volatility diminishes as a result – it should relative economic performance has now confirmed its impact on the pound.
On that score, the euro bloc seems more open to headwinds ahead.
A mix of political logjams in Berlin and Paris and the eurozone's exposure to US goods import tariffs darken the immediate outlook there more than it does for Britain and the widening rate gaps already reflect some of that.
The HSBC team says that goods make up just 42% of total UK exports but around 65% for the euro zone. In addition, Britain is the second largest exporter of services in the world and more than a quarter of these go to the US economy which is expected to grow rapidly through the next year.
The BoE's policy rate of 4.75% remains the highest of the G7 economies, including the United States. But UK rates are likely to fall faster than equivalent US rates in 2025, although not as much as the already much lower ECB rates.
That leaves the pound somewhere over the mid-Atlantic, which could benefit the euro as it falls back against a strong 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 may take the pressure off that score.
It may be much harder for Britain to get the best of both worlds – but currency markets seem to be giving it the benefit of the doubt in navigating between the two worlds right now.
The views expressed here are those of the author, a columnist for Reuters.
(By Mike Dolan X: @reutersMikeD; Editing by Jamie Freed)
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