Talking Points:

  • Ebbing political risk made the Euro the strongest major currency in 2017
  • Conflicting political, economic forces locked the British Pound in place
  • Outlook may be turning increasingly worrisome for European currencies

The Euro has enjoyed an undeniably stellar 2017…

With barely over a month left to go in 2017, it feels safe to say that the past year has been decidedly rosy for the Euro. That seemed improbable on January 1, when the currency was plagued by fears of eurosceptic triumph in several pivotal elections. Still smarting after the outcomes of the Brexit referendum and the US presidential election, shell-shocked investors braced for the worst.

Reality proved to be far kinder. The status quo prevailed in the Netherlands, France elected a youthful and energetic centrist in Emmanuel Macron, Italy managed the abrupt transition from the Renzi to the Gentolini administration, and Spain muddled through a separatist flare-up in Catalonia. This coupled with an upshift in the pace of economic growth handed the single currency a gain of close to 12 percent on the year.

…but trouble may be brewing on horizon

A sense of danger has suddenly emerged however, as Germany – heretofore the bastion of stability within a shaky region – became the site of the latest political upheaval. Coalition talks aimed at securing another term for Chancellor Angela Merkel broke down, and now another election may be necessary. A speedy resolution may yet materialize, but the common unit suddenly appears vulnerable again.

The ECB is unlikely to be much help either. It has already set the near-term fate of QE asset purchases and probably won’t alter that stance at least through March as progress is evaluated. Meaningful tightening thereafter is also unlikely as recent Euro gains filter into on-year CPI calculations, slowing progress toward the inflation target. This hints that the path of least resistance may soon favor Euro weakness.

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Euro, British Pound Look Vulnerable as 2018 Draws Closer

Chart created using TradingView

Pound stuck in limbo amid conflicting political, economic forces

Meanwhile, the British Pound’s performance can be aptly described as “directionless drift”. After eleven months of seesaw volatility, the currency is a mere 2 percent away from where the year began. This makes some sense. With 16 months in the history books since the Brexit referendum, EU and UK negotiators seem to be no closer to a framework for discussion, never mind the outlines of an accord.

A wobbly political backdrop has been hardly helpful. A snap election meant to cement the authority of Prime Minister Theresa May over warring factions within the government went terribly awry, with the Conservatives losing parliamentary majority. The economy has proven resilient however, with GDP growth averaging 1.6 percent on-year and PMI data pointing to a respectable pace of non-farm activity.

Breakdown risk grows with each day without Brexit progress

Ms May’s approval rating sank below 40 percent mid-year and has not recovered since, meaning that every inch of progress on the Brexit front will have to be hard-fought. Time is not on Sterling’s side however as the two-year countdown from activation of Article 50 of the Lisbon Treaty to an abrupt divorce continues. A palace coup may yet be attempted absent a major breakthrough, complicating the situation further.

On balance, this seems to tip the scales in favor of the downside. The Bank of England has clearly indicated its reticence to embark on a lasting rate hike cycle despite accelerating inflation as Brexit-related jitters linger. Traders may soon lose patience and opt to divest themselves of GBP-denominated assets as the cliff-edge draws closer, sending a strong message to Westminster by way of a plunging currency.

--- Written by Ilya Spivak, Currency Strategist for DailyFX.com

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