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EUR/GBP: To parity or not to parity?

Wed, Dec 24 2008, 14:53 GMT
by John Hydeskov

Danske Bank A/S


    • A year ago, parity in EUR/GBP was a distant fantasy. Now, traders attach more than 30% probability that the pair will rise above 1.00 within three months. But how severe is the situation for the pound? Why has sterling ended up being the least wanted G10 currency in 2008? What would it take to push sterling the final step above the 'magic' parity? Is it likely to happen?

    • We conclude that another downward revision of UK growth prospects relative to the Euro zone, or an adoption of quantitative easing from the Bank of England's Monetary Policy Committee, another downturn in financial equities, or a further rise in implied FX volatility could potentially push EUR/GBP beyond 1.00. However, we believe that such an erratic move would not prove long-lived.

    What would it take to push EUR/GBP to parity?

    EUR/GBP is affected by a number of factors, and we cannot identify which dominates since this varies over time. From calculations on our short-term financial model (see FX Market Update), we find that relative interest rates (3M-1Y forward spread) and carry-to-risk (3M deposit spread in relation to expected FX volatility) describe movements in EUR/GBP best, but other factors can be important drivers over shorter periods.

    We note that the rise in EUR/GBP since August 2008 has occurred at a time when downward revisions of growth forecasts for both 2008 and 2009 have been sharper for the UK than for the Euro zone, cf. table 1. In the same period, the Euro zone- UK swap spread narrowed 155bp (chart 3), 3M implied EUR/GBP volatility has risen 11 percentage points (chart 4), the UK financials index has shed around 750 index points (chart 5) and EUR/GBP has risen 26 big figures (close to 40%).

    Under the simplified assumption that these factors are separable and non-integrated, and based on the experiences from August 2007 to today, we can estimate what would be required to push EUR/GBP towards parity from the current spot level (0.9450):

    1. A further downward revision of the forecast for UK economic growth of around
    0.2-0.4 percentage points relative to the Euro zone.

    2. The 2Y Euro zone-UK swap spread widens from 0bp to 30-40bp.

    3. The FTSE100 financials index declines by a further 200 index points.

    4. The EUR/GBP 3M implied FX volatility rises by 3 percentage points.

    In our view, 1-4 are likely to happen. Why?

    Ad 1): Declining retail sales is slow poison for the consumption-driven UK economy, but we are still nowhere near the slump in consumption that we saw in the early 1990s after the burst of the previous housing bubble. We are aware that the UK export sector is in a favourable situation because of the weak pound, but since other countries are rapidly scaling imports back, the effect from UK exports on GDP will probably be smaller than under ‘normal’ conditions. The risk on UK growth in 2009 is in our view very much on the downside.

    Ad 2): The MPC has not formally adopted quantitative easing like the Fed, but it has come quite close verbally. The recent Minutes from MPC meetings adopted a very soft tone and we would therefore not be surprised to see the UK base rate at 1% or perhaps even lower in the near future. Inflation is no longer a concern. Such a scenario is not (yet) a valid option for the ECB. A rate reduction to 1.5% will probably be the lowest level the ECB will go to, assuming the economic situation doesn’t deteriorate even further. A widening of the Euro zone-UK swap spread is therefore a reasonably strong possibility.

    Ad 3): Risk on the financial sector is still considered to be on the downside. For example, Barclays Bank, HSBC and RBS were all downgraded by Standard & Poors on Friday 19 December. It is not our base scenario that bank shares will continue to decline even further, but as long as the future conditions for banks remain somewhat unsettled and sentiment is downbeat, another slump cannot be ruled out. Ad 4): Volatility is very high compared to historical standards, and one has to be pretty creative to envisage what could push market implied uncertainty higher. The ongoing financial crisis has however taught us to think the unthinkable and unforeseen events have the power to push implied volatility higher as this measure theoretically has no upper limit.

    Summarising 1-4, we cannot rule out a move in EUR/GBP to 1.00. This would most likely be interpreted as a crisis of confidence for the pound. If confidence is lost, it would require more dramatic measures such as central bank intervention or the provision of higher interest rates on sterling assets at the expense of monetary stimulus to the real economy. The result could be that we would have to revise our long-term view on the valuation of sterling, i.e. start to think of sterling as being worth the same or even less than the euro, if the pound no longer enjoys the same privileges as the common European currency in the minds of investors.

    However, we are not there yet. We regard sterling as being meaningfully undervalued against the euro. In fact, EUR/GBP is now close to 20% above its long-term fair value, cf. chart 7. Nevertheless, this misalignment could be maintained for a long time.

    Published on  Wed, Dec 24 2008, 15:02 GMT


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    Danske Bank  | Holmens Kanal 2-12, DK-1092 Copenhagen
    http://www.danskebank.com/ | danskeresearch@danskebank.com

    Legal disclaimer and risk disclosure

    This publication has been prepared by Danske Bank for information purposes only. It is not an offer or solicitation of any offer to purchase or sell any financial instrument. Whilst reasonable care has been taken to ensure that its contents are not untrue or misleading, no representation is made as to its accuracy or completeness and no liability is accepted for any loss arising from reliance on it. Danske Bank, its affiliates or staff, may perform services for, solicit business from, hold long or short positions in, or otherwise be interested in the investments (including derivatives), of any issuer mentioned herein. Danske Bank's research analysts are not permitted to invest in securities under coverage in their research sector. This publication is not intended for private customers in the UK or any person in the US. Danske Bank A/S is regulated by the FSA for the conduct of designated investment business in the UK and is a member of the London Stock Exchange. Copyright () Danske Bank A/S. All rights reserved. This publication is protected by copyright and may not be reproduced in whole or in part without permission.

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