Sterling is being buffeted by short-term noise but Brexit is the big storm

Will sterling reach parity against the euro? Over the past decade this critical currency “pair” has tendered to gravitate towards 85p (the amount of sterling one euro will buy) but has briefly approached 98p in the first half of 2009 and has been as low as 67.5p as recently as 2015.

While currencies have a deserved reputation for sudden, violent and unexpected volatility, exporters haven’t had to worry too much about sterling for most of the past decade. Currency crises, unlike the banking variety, have been noticeable by their absence. Yet if the current sterling weakness isn’t a full-blown crisis it is certainly a major headache for many companies.

The strength of the euro is not just a problem for anyone trying to sell into the UK. It’s a massive complication for the ECB who would have hoped by now, with the European economy in strong recovery mode, to have begun to wind down some of its aggressive money-printing (apologies to any German readers – of course, quantitative easing should never be called that).

Hawkish members of the ECB governing council are having a fit of the vapours right now: interest rates are not supposed to be this low when economies are this strong.

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Even Italy is growing again, something that hasn't been said for nearly two decades. And with unemployment falling pretty much everywhere around Europe, conventional wisdom is that wage inflation can't be too far behind.

The ECB is supposed to be ahead of all this – its mandate is to hike interest rates before wages take off. Mario Draghi is clearly in no hurry to do anything too prematurely, and is being helped by the simple fact that the European labour market is not behaving as it is supposed to. There are no signs of wage inflation anywhere. And the strong euro puts downward pressure on inflation.

The euro is strong mostly because the European economy is doing so well. The continent is growing faster than both the US and, particularly, the UK.

Political stability

Europe represents a haven of political stability when compared to Britain and America. Some (but by no means all) of the design flaws of the euro are slowly being rectified.

Even the potential of an anti-euro government being elected in Italy has been greeted by the markets with a yawn: Italy is always on the brink of some political precipice or other but usually muddles through. That judgment may or may not prove to be overly sanguine.

Most forecasters seem to think that a move by sterling through parity is unlikely. That’s understandable: the UK currency is undoubtedly “cheap” in terms of fundamental value and, against a basket of currencies, seems to have hit an all-time low. When we observe moves as extreme as this we can usually be confident that some reversal is likely. What goes down does sometimes go up.

That said, sterling has been in trend decline (with lots of ups as well as downs along the way) for many decades now.

In fact, according to Bank of England data, sterling, broadly measured, is currently close to a 168-year low. But that fall started before the second World War, and was largely a reflection of poor UK economic performance.

Curiously, the pound experienced a prolonged period of relative stability following the UK’s entrance into the EU in the early 1970s. If exchange rates are a measure of relative economic strength, that period of sterling stability can be seen as a response to the successful move to stabilise the UK’s long-term relative economic decline via participation in Europe’s common market (the old name for the EU). Of course, the most recent fall of the pound is the clearest signal of market opinion about Brexit’s negative impact on the UK’s long-term economic prospects.

Mug’s game

No column on exchange rates is ever complete without a warning that they are unforecastable: it’s a mug’s game. That’s mostly true. But it does seem that over time exchange rates move to reflect economic fundamentals.

Germany’s currency always tended to rise along with the productivity of its economy, for example. Brexit’s hit to UK economic prospects is, at least in part, now in the price.

I suspect that the "no deal" Brexit so beloved of the hardliners is not yet in the price: should this come about, or the market start to worry about it, then sterling will probably make an assault on parity.

However, the UK government is slowly stepping back from this position: the most recent position paper on the role of the European Court of Justice was both sensible and a welcome U-turn on previous proposals. More of this and the pound should at least stabilise if not recover.

Sterling will be buffeted by the usual short-term noise: if the economy continues to weaken, for example, that will be a problem. But the bigger deal, Brexit, will continue to be the main driver.