Is GBP Headed For USD, EUR Parity?

thenews 2016.10.05 03:31

The two primary themes in the foreign-exchange market Tuesday was sterling weakness and U.S. dollar strength. In many ways, these two trends came hand in hand as sterling’s losses were compounded by the rise in the dollar while the dollar’s attractiveness was driven by problems in Europe. Investors sought safety in the greenback but improvements in U.S. data along with the prospect of a strong nonfarm payrolls report on Friday made the dollar shine brighter than any other currency. The uptrend in the dollar is strong and corrections could be shallow ahead of NFPs. No major U.S. economic reports were released on Tuesday but comments from Fed President Mester certainly contributed to the gains. If you recall, Mester was one of three Fed FOMC voters to dissent from last month’s meeting and vote in favor of an immediate rate hike. She believes that rates should rise in November, which may be consistent with her hawkish bias but a move next month is unrealistic especially with the U.S. presidential election happening and Brexit back in the headlines.

Sterling fell to 31-year lows versus the U.S. dollar today and 5 lows versus the euro. The currency had been under pressure for the past few weeks but now that key support levels have been broken, many are wondering if the British pound will hit parity versus the U.S. dollar and/or euro. To be clear, sterling has in the past 45 years NEVER traded at parity with the euro or the euro -- not after the ERM crisis in Britain when the Soros broke the Bank of England and certainly not after the euro was launched and it sank to a record low of 0.8440. The lowest that sterling has fallen in the past 45 years versus dollar is 1.0520, and that was in February 1985. The weakest it has ever traded versus the euro as 0.9805 in December 2007. For GBP/USD to hit parity, it would need to fall another 20% and for EUR/GBP to reach that same value, it would need to rise 14%. Given how fast sterling has fallen in the past month, it does not seem implausible, but for that to happen, the process of Brexit would need to decimate the U.K. economy.

While we believe that the U.K. economy will suffer from Brexit, we do not believe that it will destroy it. First, recent U.K. data has been quite good with manufacturing and construction-sector activity improving significantly. U.K. PMI services are scheduled for release on Wednesday and between these upside surprises and stronger consumer confidence, we believe this report will be firm as well. Of course, investors are completely discounting all of these reports as temporary blips because they remember how much the data fell after Britain voted to leave the European Union. But it's important to realize that the U.K. economy is growing right now and that the government’s top priority will be to protect that growth over the next few months. Second, the 16% decline in GBP/USD over the past 3.5 months is extremely positive for the economy. It will boost trade activity, encourage tourism, support stocks and encourage cross border acquisitions. Third, investors aren’t going to pull all of their money out of U.K. assets -- London is still a hot spot for investments by foreigners and rest assured the May government will be incentivizing businesses to keep operations in the U.K., starting with a lower corporate tax that will be nearly 40% less than Germany

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