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POUND-EURO PARITY COMES EVER CLOSER

JANE FOLEY<br />RESEARCH DIRECTOR, FOREX.COM<br /><br />ALMOST a year after the pound touched parity with the euro, the recent rapid drop in the value of the pound has raised speculation that euro-sterling could see parity again in the not too distant future. Sterling-dollar &ndash; cable &ndash; is also at risk of even more losses now that it is nearing key technical support.<br /><br />Faced with an appalling set of government finances in the UK and the unhealthy nature of the country&rsquo;s economic backdrop, neither of these risks can be easily shrugged off. In the medium-term, some respite is likely to come next year as the UK economic recovery is likely to start outpacing that of the Eurozone. But in the near-term, the degree to which the pound weakens will be influenced by the policy decisions taken by the Bank of England.<br /><br />A key factor behind the recent sell-off in the pound has been a rise in speculation that the Bank of England may be &ldquo;reflecting&rdquo; on lowering the rate paid on commercial banks&rsquo; deposits held at the Bank. This speculation, which had unnerved the pound in the hours ahead of the September Monetary Policy Committee (MPC) meeting, then came to the fore following comments from Bank governor King last week. The tone taken by King suggests that he remains underwhelmed about the durability of the forthcoming economic recovery. <br /><br />Also, despite the huge amount of monetary and fiscal stimulus in the system King still thinks that the spare capacity in the economy will continue to push down on inflation potential. His tone implies that the risk of MPC easing remains tangible at a time when the European Central Bank (ECB) is perceived to be maintaining a steady hand and. Last night the US Federal Open Market Committee (FOMC) said that it would keep interest rates at record low levels, but upgraded its assessment of the USeconomy, boosting the dollar. <br /><br /><strong>NO COMFORT</strong><br />The tone of this week&rsquo;s Quarterly Bulletin from the Bank offers no comfort for the pound. It suggests that in the years prior to the financial crisis the real sterling exchange rate may have moved above its long-run sustainable position. It also notes that sterling&rsquo;s fall has taken the real value of the pound back to around its level in the mid-1990s, which itself was close to the average level in the preceding 20 years.<br /><br />If the Bank of England is unconcerned about the fall in the pound over the past two years, there are two factors which would alter this. The first would be if the pace of sterling&rsquo;s plight picked up. The second factor would be if the Bank&rsquo;s inflation projections began to head higher. The pace of a currency&rsquo;s movements is often more a source of concern than its absolute level. A steady exchange rate makes hedging and investment decisions easier and policy decisions more straightforward for a central bank. It is feasible that the MPC would not be rattled by a slow move towards parity in euro-sterling but a rapid decline with the potential to upset gilts buyers and scare away investment would rattle a few nerves. <br /><br />It is easy to have sympathy with the view that spare capacity in the economy is bearing down on inflation, but UK inflation remains sticky on the downside. Once again, UK August consumer prices index (CPI) came in stronger than expected last week. At 1.6 per cent year-on-year it is now below the Bank&rsquo;s 2 per cent inflation target. <br /><br />But, despite global recession and an inflation rate of -0.2 per cent year-on-year in the Eurozone, it is only the third consecutive month that UK inflation has been below 2 per cent. The Bank&rsquo;s projections in the spring that inflation would fall significantly in the autumn have morphed into the view that inflation will be volatile in the months ahead. If sterling were to drop dramatically, then there would be greater reason to expect &ldquo;sticky&rdquo; inflation to persist. <br /><br />Sterling is likely to be vulnerable in the run-up to the October MPC meeting and again into November given the potential for further policy action. In the meantime, the likelihood that the market is short of the pound makes it very vulnerable to better-than-expected news. <br /><br />This month&rsquo;s policy announcement allayed some nerves for the pound and the minutes of the meeting released yesterday showed no dissenting voices this month &ndash; though it is worth noting that for the two remaining members who had voted for a larger stimulus in August, a larger asset purchase programme could still be justified. <br /><br />Similarly, signs that the rally in euro-sterling is losing momentum could push the pair a little lower near-term. However, any such dips could be a good buying opportunities ahead of the MPC meeting on 10 October. ResearchEMEA@forex.com