On Tuesday (December 10), the British pound continued its upward momentum against the euro, reaching its highest level in two and a half years, with the exchange rate hitting 82.50 pence per euro, the highest since April 2022. The pound also performed strongly against the dollar, trading at $1.2758, outperforming most G10 currencies. This week marks the fourth consecutive week of the pound's gain against the euro, with traders expecting the Bank of England's policy stance to be more moderate, while the European Central Bank may increase rate cuts to boost the eurozone economy.
There is a stark contrast between the policy divergence of the Bank of England and the European Central Bank. With steady UK economic growth and high service sector inflation, the Bank of England is more cautious about rate cuts. Elias Haddad, senior market strategist at Brown Brothers Harriman, noted, "Continued inflationary pressure in the UK service sectors forces the Bank of England to be more cautious when implementing an easing policy cycle, while the ECB needs to exert more effort in facing eurozone economic weakness."
Swap market data shows that the Bank of England is expected to only loosen rates by 82 basis points by the end of 2025, whereas the European Central Bank is expected to cut rates by 152 basis points. This suggests that future interest rates in the UK will be significantly higher than in the eurozone, providing further support for the pound.
Why is the Pound Strong? Interest Rate Differentials and Economic Resilience are Key Factors
The advantage of interest rate differentials is undoubtedly the main driver behind the pound's strength. Compared to the eurozone economy, which relies heavily on exports, the UK's greater reliance on the service sector makes it less affected by external trade conditions. For instance, with the US potentially imposing tariffs on certain European export goods, the eurozone's export-oriented economy faces significant risks, whereas the impact on the UK is limited.
Moreover, the resilience of the UK economy, with inflationary pressures remaining high in some sectors, requires the Bank of England to be more cautious in policy-making. This economic performance contrast further boosts market confidence in the pound.
European Central Bank Under Pressure, Euro Facing Downward Pressure
In contrast to the pound's strength, the euro is weakening. The market generally expects the European Central Bank to cut rates again on Thursday and further reduce borrowing costs in the coming months to support economic growth. Additionally, the political deadlock in France and Germany complicates policy-making in the eurozone. The combination of economic and political pressure is weighing on the euro, and market confidence in the eurozone's economic recovery is significantly low.
Interest Rate Advantage May Continue to Support the Pound
Looking ahead, the strong performance of the pound may continue, especially if the Bank of England maintains higher interest rates. Conversely, the ongoing expectation of rate cuts by the European Central Bank may subject the euro to greater depreciation pressure. However, it should be noted that uncertainties remain in the UK economy itself, and future trade policies and changes in the global economic landscape could still pose challenges to the pound's trajectory.
Investors need to closely monitor upcoming central bank policy statements and economic data to assess the future direction of monetary policy and its impact on exchange rates. In the context of widening interest rate differentials and divided market expectations, the pound's strength against the euro may continue in the short term, but its long-term trend will still depend on global economic dynamics.
