UK Pound vs Euro: Decoding the Currency Dance Post-Brexit

At the dawn of 2021, the British pound stood approximately 15% weaker against the euro compared to its position on the eve of the UK’s pivotal referendum on European Union (EU) membership in June 2016. This devaluation is even starker when considering the broader timeline, with Sterling languishing 20% lower than its value when the EU Referendum Act received Royal Assent in December 2015.

The past half-decade has seen Brexit emerge as a dominant force shaping exchange rate volatility and the pound’s valuation against major global currencies. The immediate aftermath of the referendum vote vividly illustrated this impact, as sterling endured its most precipitous single-day decline in three decades. This initial shock was followed by further substantial and sustained drops in 2017 and 2019, driving the pound to new nadirs against both the euro and the dollar by August 2019, as visually represented in Figure 1.

This depreciation largely stemmed from mounting expectations of increased trade barriers between the UK and its foremost trade partner, coupled with heightened uncertainty and persistent political instability. These factors prompted financial institutions to offload pound-denominated assets. As the sell-off of sterling assets intensified, the pound’s value inevitably diminished relative to other currencies, particularly the euro.

Figure 1: GBP/EUR Exchange Rate Fluctuations (2015-2021)

Source: Bloomberg

Understanding Exchange Rate Dynamics

An exchange rate, at its core, is simply the price of one currency expressed in terms of another. Like any price in a market economy, it fluctuates based on the fundamental principles of supply and demand. In the context of currency exchange, this means that within a currency pair, one currency will appreciate (increase in value) while the other depreciates (decrease in value) as market participants increase their demand for the former and sell off the latter.

The significant weakening of sterling since the 2016 referendum fundamentally signifies a decrease in the global demand to hold pounds relative to other currencies, most notably the euro. Therefore, to comprehensively understand the underlying factors driving Brexit-related exchange rate movements, particularly the Uk Pound Vs Euro dynamic, we must delve into the elements that influence the demand for a currency.

Key Players in Exchange Rate Shifts

Organizations engaged in international trade of goods and services are crucial and well-established participants in the intricate world of currency markets. This includes multinational corporations involved in cross-border sales, as well as individual travelers exchanging currency for personal expenditure. For instance, when a UK resident or company imports goods from a Eurozone country, they must convert pounds into euros, thereby increasing the demand for euros and potentially impacting the uk pound vs euro exchange rate. Significant shifts in international trade patterns can therefore exert considerable influence on currency demand and valuation.

However, the rapid and substantial depreciation of sterling following 2016 occurred before any tangible alterations in the trading relationship between the UK and the EU had materialized. Furthermore, trade in goods and services, while important, is not the primary driver of overall foreign exchange transactions and typically does not exhibit sharp fluctuations in the short term (Bank for International Settlements, BIS, 2019). This suggests that changes in the trade of goods and services may not be the primary catalyst for the extreme exchange rate volatility observed and might not be the principal reason for the pound’s decline against the euro in the wake of Brexit.

A more critical factor behind the sharp falls in the pound’s value against the euro since 2016 is the marked decrease in the preference of financial institutions to hold investments denominated in pounds. The trading of currencies for investment purposes, or the trade in financial assets, constitutes the largest segment of currency transactions and is typically the most significant driver of exchange rate fluctuations, particularly in the short run and especially when considering the uk pound vs euro relationship.

This type of capital movement is often referred to as ‘hot money’ – capital that exhibits high mobility, capable of swiftly shifting between investments or currencies on a large scale, and thus rapidly influencing exchange rates. Consequently, the dominant and most influential players in currency markets are financial institutions, including major banks, securities firms, and institutional investors.

In 2019, financial institutions (excluding foreign exchange dealers) accounted for a staggering 57.8% of foreign exchange turnover in the UK. In stark contrast, only 4.9% of currency exchange volume was directly attributable to non-financial customers (BIS, 2019).

Moreover, the UK’s persistent trade deficit, where imports consistently exceed exports, results in a current account deficit. This deficit increases the nation’s reliance on ‘the kindness of strangers’ to finance its economy and renders the pound more susceptible to the ebbs and flows of international capital. This vulnerability arises because the current account deficit has become increasingly dependent on these capital inflows. Any perceived risk to these inflows can quickly translate into downward pressure on the pound, particularly against a stable currency like the euro.

Brexit’s Impact on Pound’s Appeal

The primary factors that resonate with financial institutions operating in currency markets are those that dictate the returns on investments denominated in different currencies. Consequently, the depreciation of sterling against the euro and other currencies in the Brexit aftermath strongly indicates that financial market participants anticipated that investments in pound-denominated assets would underperform compared to their potential performance had the UK remained within the EU.

Numerous factors can potentially influence returns in currency markets, and isolating the individual effects of each is a complex undertaking. Nevertheless, some of the most prominent factors typically include shifts in relative interest rates, alterations in perceived risk, and evolving overall expectations of investors, all playing a role in the uk pound vs euro exchange rate.

Interest Rates

Changes in interest rates, or factors that are expected to influence future interest rates, are widely recognized as primary drivers of exchange rates. This is because domestic interest rates can directly impact the relative attractiveness of assets in different countries. A reduction in interest rates within a country diminishes the returns on assets linked to that rate. An unexpected decrease in interest rates, holding other factors constant, will lead to a reduced demand for those assets relative to comparable assets in currencies offering higher returns, such as the euro. This, in turn, will induce a fall in the value of the currency in question.

For example, in response to the Leave vote, the Bank of England lowered interest rates in August 2016 from 0.5% to a historic low of 0.25% and expanded its program of ‘quantitative easing’ (QE). However, it is crucial to note that this policy adjustment was announced weeks after the Brexit referendum. Therefore, the significant initial plunge in the pound’s value in June 2016, or subsequent depreciations, cannot be solely attributed to the immediate reaction of financial market participants to this specific interest rate cut. The expectation of future economic downturn and further rate cuts, however, could have contributed to the longer-term downward trend of the pound vs euro.

Uncertainty and Political Instability

Changes in perceived risk are another potent factor that can significantly affect expected returns and shape investors’ decisions regarding which assets, including currencies, to hold. Heightened uncertainty surrounding factors such as future company performance, the overall economic outlook, anticipated interest rate movements, and political stability can all increase the perceived risk associated with holding assets in a specific currency. This increased risk can deter or delay investment inflows (Pindyck, 1991).

The heightened probability of increased trade frictions between the UK and the EU post-Brexit significantly amplified these risks for assets denominated in pounds. Research conducted prior to the referendum accurately predicted substantial declines in foreign investment in the UK as a direct consequence of Brexit-related trade costs (Dhingra et al, 2016).

These economic risks were further compounded by substantial and persistent political instability within the UK, which prolonged and intensified the uncertainty surrounding post-Brexit trading relationships and the likely long-term economic trajectory. The most pronounced and sustained falls in the pound’s value against the euro since 2016 were demonstrably linked to periods of heightened uncertainty and associated political turmoil.

One of the most dramatic depreciations of sterling against the euro occurred in 2017. This followed a snap general election which resulted in a hung parliament, further clouding the political landscape and economic outlook. In 2019, the pound plummeted to a new multi-year low against both the dollar and the euro within days of Boris Johnson assuming office as prime minister and his explicit refusal to rule out the possibility of a ‘no-deal’ Brexit – widely considered the most detrimental potential economic outcome for the UK.

There is accumulating empirical evidence indicating that the negative repercussions of this persistent uncertainty on employment levels, productivity growth, and investment within UK businesses became increasingly apparent in the years immediately following the referendum (Bloom et al, 2019).

Expectations

Crucially, the significant depreciation of the pound against the euro and other currencies largely occurred before Brexit had actually taken place. Conversely, exchange rate movements were comparatively muted when the UK formally exited the EU and the transition period concluded at the end of 2020. This temporal discrepancy underscores the pivotal role of investor expectations in shaping currency movements (Dornbusch, 1976; Engle and West, 2005).

Shifting investor expectations are rapidly and efficiently incorporated into currency markets due to the sheer volume and velocity of trading activity. Any new information that alters expectations regarding a currency’s future prospects will be swiftly reflected in exchange rates. If market participants anticipate a negative future impact on investments denominated in a particular currency, they will proactively sell off that currency, causing its value to decline. This is clearly seen in the uk pound vs euro exchange rate post-Brexit vote.

The unprecedented plunge in the pound’s value immediately following the referendum serves as a stark illustration of the rapid and profound impact of changing market expectations on currencies. The Leave vote outcome caught many financial commentators and market participants by surprise. Last-minute polling data had suggested a likely victory for the Remain campaign, which had initially caused sterling to appreciate modestly in the days leading up to the referendum. The subsequent collapse in the pound’s value immediately after the result was announced vividly highlights the deeply negative expectations that financial market participants harbored for sterling-denominated investments in the wake of the Leave victory.

The substantial falls in the pound in 2017 and 2019, during periods of heightened political uncertainty, further underscore this point. These depreciations also reflect increasingly pessimistic expectations for sterling-denominated investments driven by the growing probability of a ‘hard’ Brexit scenario. Conversely, periods of improved optimism regarding a more orderly Brexit process and the prospect of a comprehensive trade deal were often preceded by increases in the pound’s value against the euro and other currencies.

Recent academic research has further solidified the specific links between economic policy uncertainty and exchange rate expectations (Beckmann and Czudaj, 2017). These findings strongly suggest that market participants actively consider the prevailing level of policy uncertainty when formulating their expectations about currency valuations and future exchange rate movements, especially in the context of the uk pound vs euro pair.

Consequences of Sterling’s Depreciation

One immediate and tangible consequence of a fall in sterling’s value, particularly against the euro, is that goods, services, and assets originating from countries within the Eurozone, and indeed globally, become more expensive for UK residents and businesses. This directly translates into higher levels of imported inflation and a rise in the overall cost of living for UK households.

However, a weaker currency, such as the pound against the euro, can also present potential benefits. It can enhance the international competitiveness of a nation’s exports by effectively reducing the cost of domestically produced goods and services for consumers in other countries, particularly within the Eurozone. This enhanced export competitiveness can potentially lead to positive outcomes for the country’s trade balance, potentially reducing the trade deficit, and contribute to overall aggregate economic growth.

Nevertheless, academic research examining the net balance of these effects following a currency depreciation, like the pound vs euro post-Brexit, is, at best, mixed and inconclusive. Furthermore, the persistent uncertainty surrounding the scale and long-term implications of post-Brexit trade frictions continues to obscure the likely overall economic outcome for the UK. To fully comprehend the longer-term consequences of the Brexit-related depreciation of sterling, particularly its sustained weakness against the euro, further in-depth research and analysis are essential.

Experts on Exchange Rates and Currency Markets:

Mark P. Taylor (Washington University)
Ronald MacDonald (University of Glasgow)
Keith Pilbeam (City, University of London)
Jeffrey Frankel (Harvard University)
Christopher Coyle (Queen’s University Belfast)