Pound Drops Versus Euro as Brexit Talks Remain In Deadlock

01.09.17
3 minute read
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Very little progress appears to have been made in Brexit talks, which has dampened the mood for the pound considerably. In the previous session the pound dropped 0.2% versus the euro and is heading into Friday at €1.0860, around 100 points above its recent 8 year low hit earlier in the week.

Brexit talks appear to have hit a deadlock. The EU is still insisting that more progress must be made regarding the Divorce Bill, which includes topics such as the cost of Brexit, the rights of citizens and Northern Ireland’s borders. Meanwhile Britain is arguing that the Divorce Bill must be discussed in parallel to future trading relations. The problem with the stalemate is that time is running out on an already very tight schedule.

Should no deal be reached by the end of the two year deadline, then a no deal Brexit is a very real possibility. This cliff edge style break from the European Union would be disastrous for UK businesses and the UK economy alike. Unless the two sides start to move forward in the negotiations then a smooth Brexit could well be off the table and these concerns are weakening demand for sterling.

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.

Looking ahead, the manufacturing purchasing managers index will be released this morning. This data could offer sterling some support, should the figure show resilience in the manufacturing sector as we head through Brexit. Manufacturing is expected to hold up fairly well and continue expanding as the weaker pound means UK products are cheaper for foreign buyers to purchase. However any boost from strong data is likely to be temporary at best as Brexit talks will continue to be the main driver for the pound.

Eurozone inflation higher, but not core inflation

Meanwhile, euro traders failed to get excited over the better than forecast inflation figures for the eurozone. Even so, that didn’t prevent the pound dropping lower against the euro. Eurozone inflation rose to 1.5% year on year, ahead of last month’s 1.3%. However, core inflation, which excludes volatile energy prices, remained stagnant. This is what is keeping the euro subdued, as ECB President Mario Draghi has clearly stated that it is necessary to look through volatile energy prices when setting monetary policy, implying core inflation figures are the one the watch. Therefore, the odds of an interest rate rise didn’t increase following the inflation reading which is why the euro hasn’t advanced.

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.
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