What does the value of the pound tell us about Brexit?

The pound rose against the dollar on Thursday night and Friday on renewed hopes that a no-deal Brexit will be averted. That outcome is potentially less likely after a report that the Democratic Unionist Party is willing to back Theresa May’s “Plan B” in a vote next Tuesday.

It’s the latest ascent in what has been a very bumpy ride for sterling over the last three years. Each time politicians seem to be veering the country closer to a cliff-edge Brexit, the currency plunges; every time a compromise appears likely, sterling gains in value.

Adam Cole, head of FX strategy at RBC Capital Markets, predicts that a no-deal Brexit – seen as disastrous for the UK economy – would wipe 10 per cent off the value of the pound.

At the other end of the spectrum of potential outcomes, Cole predicts that a Final Say referendum and a vote to remain would see sterling gain 10 per cent.

Brexit is comfortably the biggest driver behind sterling exchange rates at the moment, Cole says.

So it would be easy to think that currency movements could tell us something about the progress of Brexit talks. Perhaps, but it would be unwise to read too much into it.

Markets might simply be wrong about the likely outcome.

We often talk about markets as if they are definable, tangible entities but in reality they are huge numbers of companies, investors, traders and brokers buying and selling to each other.

The price of the pound is an aggregation of millions of transactions between those participants. More sellers and the price will go down, more buyers it will go up; simple supply and demand.

While many of these participants have a significant financial interest in correctly predicting the movement of currency values, they frequently get things wrong.

Banks spend vast sums applying statistical models and researching down to the tiniest detail in order to get an edge in currency markets.

But that doesn’t necessarily mean they have any special information that allows them to predict the outcome of a political process that, it is fair to say, has been less than smooth.

The report on the DUP that has helped boost the pound wasn’t special insider knowledge obtained only by financial institutions; it was printed in The Sun.

The Brexit referendum itself is a clear example of currency markets being a poor predictor of a political event. The pound suffered its biggest single-day plunge ever on 24 June precisely because most market participants thought the UK would vote to remain.

If they had predicted it correctly, the decline in sterling would have taken place before the vote and not have been so painfully sudden.

The 2016 vote was a simple binary choice on which there had been reams and reams of polling. The current political situation is anything but. It has many potential outcomes, none of which seem to be truly understood, even by some of the MPs arguing for them.

The second reason not to set too much stall by the currency market as a political sage is that there are a host of other factors beyond politics that affect exchange rates.

Interest rates are the most obvious and closely correlated. A higher return attracts foreign investment, pushing up demand for the pound and therefore the price.

Which leads to a related point: currencies are always priced in pairs. Pound v dollar, euro v ruble etc.

So if demand for the other currency in that pair increases, the pound will suffer a relative decline.

On Friday, the pound rose 0.7 per cent against the dollar but fell slightly against the euro. Events in Europe had strengthened the single currency, events that had nothing to do with the Brexit saga.

While it would be nice to have a handy index illuminating the road ahead, the value of the pound is only of marginal use in this regard.

In other words, when it comes to Brexit, it’s still anybody’s guess.

Got an unanswered question about Brexit? Send it to editor@independent.co.uk and we’ll do our best to supply an answer in our Brexit Explained series