All the theories behind the pound's surprising rise

  • Sterling is the strongest performer in the G10 basket of major currencies over the past six months when compared to the US dollar.
  • The pound has strengthened significantly in 2018, but what is behind that increase in value?
  • Numerous factors, ranging from the increased markets now seem to have in the UK and EU to strike a Brexit deal, to falling confidence in the agenda of US President Donald Trump, are playing a role.

LONDON – 2018 has started with a bang for the pound.

Sterling has gained several per cent against the dollar in just a few weeks, continuing the strong performance it saw towards the end of 2017.

Sterling, in fact, is the strongest performer in the G10 basket of major currencies over the past six months when compared to the US dollar.

As of Monday morning, sterling is trading above $US1.41 against the greenback, a level not seen since the months before the Brexit referendum.

But what is behind the appreciation of a currency which for over a year was the laggard of the foreign exchange? There are several factors at play, ranging from the increased markets now seem to have in the UK and EU to strike a Brexit deal, to falling confidence in the agenda of US President Donald Trump.

Brexit isn’t going as badly as expected

Former Prime Minister David Cameron summed it up nicely this week when he was overheard at the World Economic Forum in Davos saying that Brexit has been a “mistake, not a disaster.”

“It’s turned out less badly than we first thought,” Cameron said.

Cameron’s view seems to be fairly similar to the markets, which are now far less pessimistic about Brexit than in the immediate aftermath of the vote.

One driver of that dwindling pessimism has been the better than expected performance of the British economy over the last 18 months. For sure, UK growth has slowed and is way lower than it would have been had the UK stayed in the EU, but things are nowhere near as bad as first predicted.

On Friday, for example, GDP data from the ONS showed UK showed the economy growing 1.5% year-on-year in the fourth quarter of 2017. The ONS now estimates that the economy grew 1.8% over the course of 2017.

That’s hardly explosive, but it is nowhere near the recession some predicted.

An annual figure of 1.8% for 2017 puts the UK ahead of OECD forecasts for growth in fellow G7 members Japan and Italy, both of which are expected to grow at 1.5% in 2017, and in line with France, which is expected to grow at 1.8%.

Previous estimates had suggested that UK would be easily the slowest growing G7 economy last year.

Add to this the fact that more Brits are employed than ever before, and that employment is still rising 19 months after the vote, and the economic picture is, if not rosy, certainly solid.

This is undoubtedly pound positive.

The government’s stance is softening

Philip hammond red briefcase(Photo by Carl Court/Getty Images)LONDON, ENGLAND – DECEMBER 06: Chancellor of the Exchequer, Philip Hammond, walks through Downing Street ahead of Prime Minister Theresa May’s departure for Prime Minister’s Questions on December 6, 2017 in London, England. Mrs May spoke to DUP leader Arlene Foster this morning as negotiations continue over the Irish border issue.

For much of 2017 it looked like Britain was heading for the hardest of Brexits, with a complete severing of ties with the EU, but recent words from senior figures on both sides of the negotiating table suggest that stance is softening somewhat.

This was typified by Chancellor Philip Hammond, who on Thursday said that Brexit would only lead to “very modest” changes to Britain’s current relationship with the European Union.

“We are taking two completely interconnected and aligned economies with high levels of trade between them, and selectively, moving them, hopefully very modestly, apart,” he said in a speech at Davos.

“In my opinion, starting with what we have got and working out what we need to subtract to get to a workable future model that respects everybody’s red lines is a more preferable way forward than starting with a blank sheet of paper which is what the Canada model would entail.”

Postive Brexit developments are very clearly drivers of sterling strength. Earlier in January, Bloomberg reported that “Spanish and Dutch finance ministers have agreed to work together to push for a Brexit deal that keeps Britain as close to the European Union as possible.” That news pushed the pound higher by almost 1% against the dollar. This has been a fairly frequent trend for sterling – news that seems to suggest a softer Brexit = a stronger pound.

The agreement of a transition deal for Brexit in the near future could also be a substantial boon for sterling, helping boost it even further.

“The timing and clarity of the transition deal will be key in terms of the outlook for sterling,” Roger Hallam, Chief Investment Officer for currencies at JPMorgan Asset Management told Business Insider back in December.

“It seems likely a transition deal will be agreed in the first quarter, with the terms likely to be dictated by the EU (developments over the past month have made it clear the EU is the dominant partner in the negotiations).”

Dollar weakness

TrumpKevin Dietsch/GettyWASHINGTON, DC – FEBRUARY 13: (AFP OUT) U.S. President Donald Trump (R) during a meeting with Prime Minister Justin Trudeau of Canada (not pictured) in the Oval Office at the White House on February 13, 2017 in Washington, D.C.

For sure, some of the pound’s recent strength has been related to growing confidence in Brexit, and Britain’s reasonably strong economic performance, but ultimately the pound’s recent rally is more a story of a weak dollar than a strong pound, with the greenback dragged lower by a number of factors.

As Viraj Patel, an FX strategist at Dutch lender ING notes, political risks in the USA “lie deeper than the noise around Michael Wolff’s ‘Fire and Fury’ book.”

“A change in America’s status in the world political order may have long-run economic consequences for a country reliant on ‘the kindness of strangers’ to fund its twin current account and fiscal deficits,” Patel wrote in a recent note.

“For a US economy in the latter stages of its economic cycle, such structural risks – coupled with the ambiguous economic and repatriation effects of the GOP Tax Bill, relative US asset valuations and the better goldilocks investment opportunities outside of the US – is why we retain a bearish view on the broad US dollar index over 2018.

The dollar, as a result, is dwindling in attractiveness as an investment currency, creating further weakness.

This, Patel adds, means that the dollar is “trading under new rules where an environment of rising US rates no longer guarantees dollar strength. Greater synchronicity across bond markets – amid a broadening global economic recovery – is one factor we’ve touted before.

But equally a fragile US political environment ahead of the November midterm also reduces the USD’s investment appeal.

Messaging from senior officials in the Trump administration is also causing confusion in the markets.

Ultimately, politicians should have no influence over a free floating currency, but comments from Treasury Secretary Steven Mnuchin earlier in the week that a weaker currency was beneficial to US trade sent the dollar lower, before President Trump himself intervened on Thursday, saying that the dollar would get “stronger and stronger” in the future.

Brexit and the UK’s domestic outlook may have some sway on the pound, but ultimately, it is the almighty dollar that is king.

Should the greenback keep falling in 2018, the pound will likely keep appreciating – some think it could reach as high as $US1.53. On the flipside, if the dollar stops the rot, there could be pain in store for sterling.

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