GBP/EUR: Changing Stance Over Post Brexit Transition Talks Injects Volatility

13.10.17
4 minute read
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The pound showed just how sensitive it is to Brexit on Thursday. Brexit headlines sent sterling plummeting down to over 0.7% versus the euro to a four-week low of €1.1071. Later, headlines from Brussels about the EU offering the UK a 2 year post-Brexit transition period pushed sterling up over 1% versus the euro. This took the pound euro exchange rate to a high of €1.1200, a level not seen since the beginning of the week.

What do these figures mean?

When measuring the value of a pair of currencies, one set equals 1 unit and the other shows the current equivalent. As the market moves, the amount will vary from minute to minute.

For example, it could be written: 1 GBP = 1.13990 EUR

Here, £1 is equivalent to approximately €1.14. This specifically measures the pound’s worth against the euro. If the euro amount increases in this pairing, it’s positive for the pound.

Or, if you were looking at it the other way around: 1 EUR = 0.87271 GBP

In this example, €1 is equivalent to approximately £0.87. This measures the euro’s worth versus the British pound. If the sterling number gets larger, it’s good news for the euro.

Investor hopes of a Brexit transition deal appear to be back on the table late on Thursday. Earlier in the days investors sold the pound as Chief EU negotiator Michel Barnier said that sufficient progress hadn’t been made in the first round of talks, to progress to the second stage. The second stage of talks could involve discussions on a transition deal and future EU-UK trade deals. He also went on to say that the negotiations were in fact in deadlock once again. These comments were sufficient to send the pound sharply lower as any hope of a smooth Brexit seemed to be pushed further into the distance.

Why is a smooth Brexit good for the pound?
A smoother Brexit would be a scenario in which the economic consequences of leaving the European Union are minimised. This is favourable for the pound because the less the Brexit impact on the economy, the more likely that foreign investors will remain interested in the UK. Foreign investors need sterling to invest in the country and so the more GBP is purchased, the higher the demand and, thus, an increase in the currency’s value.

Later on Thursday, the pound recovered sharply when reports surfaced that Barnier could offer the UK a 2 year post-Brexit transition period, should the UK meet its financial obligations regarding the divorce bill. The divorce bill refers to bills that the EU Commission expects UK to pay in order settle pending financial obligations before the exit. Should today bring any conflicting information regarding the transition period, the pound could find itself heading downwards again.

Draghi sends the euro lower

The European Central Bank (ECB) President Mario Draghi weighed on the mood for the euro among investors. In a key speech on Thursday, Draghi indicated that even if the ECB tapers or withdraws its current bond buying programme, interest rates are expected to remain at their ultra-low level for an extended period of time. This was disappointing news for many euro traders who had assumed that the withdrawing of the quantitative easing programme (bond-buying programme) could go hand in hand with increasing interest rates. As investor interest rate hike expectations declined, so did the value of the euro versus the pound.

With the bond-buying program, the ECB purchases corporate bonds like any other investor who would have normally bought them. Because the ECB has already acquired the corporate bonds, the investor can no longer purchase them, and therefore have money to invest elsewhere. This is how the ECB increases liquidity in the economy.

Why do raised interest rates boost a currency’s value?
Interest rates are key to understanding exchange rate movements. Those who have large sums of money to invest want the highest return on their investments. Higher interest rate environments tend to offer higher yields. So, if the interest rate or at least the interest rate expectation of a country is relatively higher compared to another, then it attracts more foreign capital investment. Large corporations and investors need local currency to invest. More local currency used then boosts the demand of that currency, pushing the value higher.

Today, euro traders will look towards German inflation figures. The eurozone as a whole is suffering from stubbornly low inflation, although this isn’t necessarily the case for Germany. Investors will be looking for signs that inflation in Germany is nearing the ECB’s 2% target level. High inflation could go some way to boosting the odds of an interest rate hike, which could in turn boost the value of euro versus the pound.

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