By most measures, the pound sterling should have a clear advantage over the euro. After all, Britain’s economy managed to surprise the markets last week with faster-than-expected growth in the third quarter, and the euro zone cut interest rates. Both of those developments point in sterling’s favor.
But the euro rose against the pound. How is that possible?
Jane Foley, senior currency strategist for Rabobank International in London, sees the battle between sterling and the euro as a contest between two weaklings.
“Sterling has negative fundamentals, and so does the euro zone,” Foley says. “The concerns about the U.K. are too significant to see sterling outperform the euro by a large margin.”
While it’s true that British GDP expanded by 0.5 percent in the third quarter, a more telling statistic was the Markit/CIPS UK Manufacturing PMI, which dropped to 47.4. For this purchasing managers’ index, any reading below 50 indicates the economy is contracting.
Hans-Guenter Redeker, head of foreign currency strategy at Morgan Stanley in London, says the real problem is that the euro zone economy is slowing down as a result of economic troubles in Spain, Italy, Portugal, Greece and Ireland, and because the euro zone is the U.K.’s largest export market, “that means the U.K. is going to suffer too,” Redeker says.
Mario Draghi, the new president of the European Central Bank, wasted no time in taking over the top job Thursday, announcing a 25-basis-point cut in the ECB’s benchmark interest rate, to 1.25 percent. The U.K.’s short-term interest rate is 0.5 percent.
Draghi warned that the euro zones’s economic growth is likely to be much worse than the bank had expected. So why did the euro rise? It was sheer relief that disaster had been at least temporarily averted: Greece’s decision to drop a planned referendum on the European bailout plan for the country buoyed markets because the vote had threatened to drive Greece from the euro.
Redeker points out that interest rates aren’t the only issue in the sterling-euro battle to the bottom. Because of the Greek crisis and the possibility of its spreading to Italy and Spain, credit default swaps on sovereign debt, which offer insurance against government default, are now higher for Germany, the locomotive of the European economy, than they are for Britain. So Europe’s higher interest rates are offset to some extent, Redeker says.
“I think both currencies are going to be weak, but it looks like the euro is going to be weaker than sterling,” he says.
Normally, sterling might have been a safe haven for investors fleeing the uncertainty in Europe. But last month the Bank of England adopted a policy of quantitative easing by authorizing the purchase of an additional £75 billion ($118 billion) to buy debt instruments from the U.K. financial markets. That is intended to drive down interest rates.
Because of the downward pressure on longer-term interest rates, Rabobank’s Foley says, it is possible that quantitative easing policy is offsetting any safe-haven benefit that the British currency might have received from the government’s austerity policy.
“If we get toward the end of next year and there are signs that the austerity program in the U.K. is bearing fruit, maybe sterling will push higher against the euro,” Foley says. “There are only very slight signs at the moment that it is bearing fruit.”
