Sterling could soon bounce back

“The pain can be felt with every British order for croissants and cappuccinos” on the continent, says the Financial Times. The pound has slid to its lowest level against the euro since 2009, with the single currency now buying around 92p, compared to 70p before the referendum in June 2016. And while sterling has recovered some ground against the dollar, in trade-weighted terms – tracking a basket of major trading partners’ currencies – it is close to 2016’s record low.

The euro has gained 10% since April, and it has the wind at its back. A sense of political drift and confusion on this side of the Channel, along with some weak recent data, has contrasted with a firmer eurozone economy and unexpectedly stable political environment. There has been talk of a leadership challenge to Theresa May in October, while any prospect of an early election “would put [the pound] under immediate selling pressure”, says a Morgan Stanley note. It raises the spectre of a Labour government raising taxes on firms and high earners, which could lead to “substantial capital outflows”.

Meanwhile, the European Central Bank is expected to reduce the pace of its quantitative easing, or money printing, programme soon, while our monetary policy is likely to stay looser for longer. The closer the prospect of interest-rate rises, the stronger a currency, as the prospective yield on its assets increases. Morgan Stanley reckons the pound is heading for parity with the euro early next year before returning to today’s levels by the end of 2018.

But is this too gloomy? Forex markets are notorious for overshooting and then snapping back quickly. The UK economy has hardly fallen off a cliff, and political instability could return to the continent if populists make gains in Italy’s election next year. What’s more, the sharp slide has already made sterling look very cheap in terms of purchasing power parity (PPP), a key currency valuation measure.

PPP posits that in the long term an exchange rate should move towards the point that equalises the prices of the same good in each country; in other words, a pound should buy the same in each country. PPP with the euro would imply an exchange rate of 82p, calculates Charles Ekins of investment managers Ekins Guinness. In the meantime, the pound has gained 8% against the dollar this year, as UBS Wealth Management’s Dean Turner told the FT. “So which indicator is right?” The upshot is that “the pound’s journey south against the euro is probably closer to the end than the beginning”.

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