Sterling Pound to Euro Exchange Rate: Decoding Brexit's Impact

Since the beginning of 2021, the sterling pound has notably weakened against the euro, sitting approximately 15% lower than its value on the eve of the UK’s EU membership referendum in June 2016. This depreciation is even more stark when compared to December 2015, when the EU Referendum Act received Royal Assent, with sterling being 20% weaker. Understanding the fluctuations in the Sterling Pound To Euro exchange rate is crucial for businesses, travelers, and anyone with financial interests spanning the UK and Europe.

Over the past half-decade, Brexit has emerged as a dominant force influencing exchange rate volatility and the value of the pound relative to major currencies. The immediate aftermath of the 2016 referendum witnessed the pound’s most dramatic single-day plunge in 30 years. Further significant and sustained declines occurred in 2017 and 2019, driving the value of sterling to new lows against both the euro and the US dollar by August 2019 (as illustrated in Figure 1).

This devaluation largely stemmed from growing expectations of increased trade barriers between the UK and its largest trading partner, coupled with heightened uncertainty and ongoing political instability. These factors prompted financial institutions to sell off pound-denominated assets, triggering a domino effect that drove down the sterling pound to euro exchange rate and its value against other currencies.

Understanding Exchange Rate Dynamics

An exchange rate represents the price of one currency in relation to another. Like any price in a market economy, it is governed by the principles of supply and demand. In a currency pair, when demand for one currency increases relative to the other, its value appreciates, and the counterpart currency depreciates.

The post-referendum decline in the sterling pound to euro exchange rate signifies a decrease in the demand to hold pounds compared to euros and other currencies. To grasp the fundamental drivers behind Brexit-related exchange rate shifts, we must identify the factors influencing the demand for a currency.

Key Players in Exchange Rate Movements

Participants in international trade, dealing in goods and services, are significant actors in currency markets. This encompasses companies engaged in cross-border trade and individual travelers exchanging currencies for personal expenses. For instance, when a UK entity purchases goods from the United States, they must convert pounds into dollars, thereby increasing the demand for dollars. Substantial shifts in international trade patterns can, therefore, impact currency demand and valuation.

However, the rapid and substantial depreciation of the sterling pound to euro rate and against other currencies since 2016 predates any actual changes in the trading relationship between the UK and the EU. Furthermore, trade in goods and services isn’t the primary source of overall foreign exchange transactions and typically doesn’t exhibit abrupt short-term fluctuations (Bank for International Settlements, BIS, 2019). This suggests that trade dynamics are not the primary catalyst for extreme exchange rate volatility and may not be the main reason for the Brexit-linked fall in the sterling pound to euro value.

A critical factor behind the sharp falls in the pound since 2016 is a significant decrease in the inclination of financial institutions to hold investments denominated in pounds. Currency trading for investment purposes, or the trade in financial assets, constitutes the largest share of currency transactions and is typically the most potent driver of exchange rate changes, especially in the short term.

This is often referred to as ‘hot money’ – highly mobile capital that can swiftly move between investments or currencies on a large scale, causing rapid exchange rate adjustments. Consequently, the most influential players in currency markets are financial institutions, including banks, securities firms, and institutional investors.

In 2019, financial institutions (excluding foreign exchange dealers) accounted for 57.8% of foreign exchange turnover in the UK, while 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, increases its reliance on international capital inflows and makes the pound more susceptible to global capital movements. This vulnerability arises because the current account deficit has become increasingly dependent on these capital inflows for financing.

Brexit’s Impact on the Pound’s Appeal

The primary determinants that financial institutions consider in currency markets are factors influencing the returns on investments in different currencies. Consequently, the Brexit-related decline in the sterling pound to euro exchange rate and against other currencies indicates that financial market participants anticipated poorer performance for pound-denominated investments post-Brexit compared to a scenario where the UK remained in the EU.

Numerous factors can potentially impact returns in currency markets, and isolating individual effects is complex. Nevertheless, some of the most influential factors are typically shifts in relative interest rates, changes in perceived risk, and evolving investor expectations.

Interest Rates

Changes in interest rates, or factors influencing them, are considered a primary driver of exchange rates, including the sterling pound to euro rate. Domestic interest rates can affect the relative attractiveness of assets in different countries. Lower interest rates in a country diminish the returns on assets linked to that rate. An unexpected interest rate cut, assuming other factors remain constant, leads to reduced demand for those assets relative to equivalent assets in other currencies. This, in turn, causes a depreciation of the currency in question.

For instance, following the Leave vote, the Bank of England lowered interest rates in August 2016 from 0.5% to 0.25% and expanded its quantitative easing (QE) program. However, this policy adjustment was announced weeks after the Brexit referendum. Therefore, the significant initial drop in the sterling pound to euro exchange rate in June 2016 cannot be solely attributed to financial market reactions to this specific interest rate change.

Uncertainty and Political Instability

Changes in risk perception can also affect expected returns and influence investor decisions regarding asset holdings, including currencies. Heightened uncertainty surrounding factors like future company performance, economic outlook, interest rates, and political stability can increase the perceived risk of holding assets in a specific currency. This can lead to reduced or delayed investment flows.

The increased likelihood of trade frictions between the UK and the EU post-Brexit amplified these risks for pound-denominated assets. Pre-referendum research predicted substantial declines in foreign investment in the UK due to Brexit-related trade costs.

These risks were compounded by significant and persistent political instability in the UK, which prolonged and deepened uncertainty surrounding post-Brexit trading relationships and the anticipated economic consequences. The most substantial and sustained falls in the sterling pound to euro exchange rate since 2016 were closely linked to heightened uncertainty and associated political turmoil.

A notable drop in sterling’s value against the euro occurred in 2017, following an early general election that resulted in a hung parliament. In 2019, the pound fell to a new multi-year low against both the dollar and the euro shortly after Boris Johnson became Prime Minister, coinciding with his refusal to rule out a no-deal Brexit – widely considered the worst-case economic scenario for the UK.

Evidence suggests that the negative consequences of this uncertainty on employment, productivity, and investment in UK businesses became increasingly apparent in the years immediately following the referendum.

Expectations

The depreciation of the sterling pound to euro exchange rate occurred before Brexit actually materialized. Conversely, exchange rate movements were relatively subdued when the UK formally left the EU and the transition period concluded at the end of 2020. This is because investor expectations play a crucial role in shaping currency movements.

Changes in investor expectations are rapidly incorporated into currency markets due to the immense volume and speed of trading. Any new information impacting currency expectations is swiftly reflected in exchange rates. If market participants anticipate negative future effects on investments in a currency, they will sell that currency, causing its value to decline.

The record fall in the pound after the referendum exemplifies the rapid impact of shifting market expectations on currencies, as the Leave vote surprised many observers. Last-minute polls suggested a likely Remain victory, initially causing sterling to appreciate in the days leading up to the referendum. The pound’s subsequent collapse immediately after the result underscores the negative expectations financial market participants held for sterling investments once the outcome became clear.

The significant pound depreciations in 2017 and 2019 coincided with periods of intensified political uncertainty. These declines also reflect increasingly pessimistic expectations for sterling-denominated investments driven by the growing probability of a ‘hard’ Brexit. Conversely, improved prospects of an orderly Brexit and a trade agreement preceded appreciations in the pound’s value.

Recent research has demonstrated specific links between economic policy uncertainty and exchange rate expectations. Findings suggest that market participants factor in the level of policy uncertainty when forming their expectations.

Consequences of Sterling’s Depreciation

One immediate consequence of a weaker sterling pound to euro exchange rate, and against other currencies generally, is that foreign goods, services, and assets become more expensive for UK residents. This contributes to higher inflation levels and an increased cost of living.

However, a weaker currency can also offer benefits by making exports more competitive. Reduced costs of domestic goods and services for residents of other countries can potentially improve a country’s trade deficit and stimulate overall economic growth.

Research on the net impact of currency depreciation is inconclusive. Moreover, ongoing uncertainty surrounding the scale and implications of post-Brexit trade frictions makes the long-term economic outcome for the UK even more ambiguous. Further research is needed to fully understand the long-term consequences of the Brexit-related fall in the sterling pound to euro exchange rate and the pound’s value in general.

Sterling Pound to Euro Exchange Rate: Decoding Brexit’s Impact