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Will EUR/GBP Hit Parity?

Last updated 2/16/2009 11:28 AM ET (GMT -5) 0 Comments - Add your comment

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Kathy Lien

Director of Currency Research, GFT

* This piece is written by Kathy Lien, Director of Currency Research 

Traditionally, EUR/GBP is known as the range trading currency. Compared to the other commonly traded currency pairs, it used to have one of the narrowest average daily and monthly ranges. For example, between 2005 and 2007, EUR/GBP traded within a 400 pip range. Granted, each point move in EUR/GBP is worth much more than a point in the EUR/USD or USD/JPY, compared to 3300 pip move in the EUR/USD during the same period, it is still nominal. However in November of 2007, EUR/GBP started acting very out of character. Instead of remaining within its tight trading range, the currency pair broke out violently to the upside. In 2 months, EUR/GBP surged 1300 pips to a record high 98 cents. Although the currency pair has retraced a good portion of those gains, the diverging outlook for the Euro and the British pound has led many traders to wonder if the currency pair could be headed towards parity (1 to 1) once again. 

What Drove the Breakout in EUR/GBP

As a country whose economy is heavily tied to the financial sector, the United Kingdom was severely affected by the credit crisis which has now turned into a global economic and financial crisis. Many banks in the country were directly exposed to the credit derivatives that sparked the severe losses and write downs plaguing the entire financial sector. The U.K. government was quick to react by nationalizing mortgage lender Northern Rock in February 2008, but that did not stem the bleeding. Over the next few months, the government responded with capital injections into banks and aggressive interest rate cuts. Since the beginning of 2008, the Bank of England has cut interest rates by 450bp to a 300 year low of 1 percent.

The Eurozone has also been hit by the economic and financial crisis but compared to the UK, their exposure to the credit and financial crisis has been less. They region is also in recession and the economy is expected to worsen, but unlike the Bank of England, the European Central Bank has not been as aggressive with cutting interest rates. Since the beginning of the year, they have only cut interest rates by 175bp and in February, they actually refrained from cutting rates. 

The U.K.’s heightened exposure to the financial crisis and their more aggressively monetary policy singlehandedly triggered the sharp breakout in EUR/GBP. 

EUR/GBP Spread Leads the Pair Higher

The following chart displays the relationship between EUR/GBP and the spread between Euro and British Pound 3 month LIBOR rates. The correlation is uncanny.  As the spread widens in the Euro’s favor due to interest rate cuts from the BoE, EUR/GBP rises. Even the latest turn in the spread has corresponded with a turn in EUR/GBP.

Can EUR/GBP Hit Parity?

Therefore, if you believe that the spread will continue to move in the Euro’s favor, then we could certainly see EUR/GBP hit parity. This would mean that 1 Euro would be equivalent to 1 British pound. In terms of growth, both countries will remain in recession for some time. Further job losses are expected and growth will continue to contract. The stubbornness of the ECB could prolong the downturn in the Eurozone and investors may continue to pull out of Eurozone investments as more countries face credit downgrades. The U.K. on the other hand remains very sensitive to the financial sector. Until we have stability on that front, more losses and write downs may be expected.

Where the two countries differ is in monetary policy. After the release of the Quarterly Inflation Report, speculators started to bet on zero interest rates in U.K. Quantitative easing is expected to be made official at the next monetary policy meeting. This means that we could see another 75 to 100bp of easing. (interest rates are currently at 1 percent).   The Bank of England is also “talking down” their currency. This morning, BoE member Bean said that a further depreciation in the pound is needed for rebalancing. 

Although more interest rate cuts are expected from the European Central Bank (rates are currently at 2 percent) as well, Trichet is opposed to taking rates to zero at this point. In fact, ECB officials have been talking about how the current level of interest rates is already very low. Therefore unless the ECB shifts its stance or we see a massive outflow out of Euros due to credit downgrades for Spain or Italy, EUR/GBP has a decent chance of hitting parity. 

EUR/GBP Technicals: Not There Yet

On a technical basis, there is nothing to suggest that EUR/GBP could hit parity at the moment. The currency pair is trading within the range trading zone which we determine using Bollinger Bands. The 0.8748 level serves as decent support as it represents the 50 percent Fibonacci retracement of the October to December rally. In order for EUR/GBP to have any chance of challenging its December high, it would need to close above 0.9300.

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About The Author

Kathy Lien began her FX trading career 10 years ago at J.P. Morgan Chase. After graduating New York University’s Leonard Stern School of Business at the age of 18, Kathy joined the bank's interbank FX trading desk and eventually moved to the cross markets proprietary trading desk. In the interbank market, her ability to create solid fundamental and technical analysis from the myriad of information on the market helped her trade forex spot and options. Her experience eventually led her to be chief strategist at Daily FX where she worked until she joined GFT in 2008.

With her knowledge of forex, as well as her experience trading other products, such as interest rate derivates, bonds, equities, and futures, Lien has built a reputation as an international currency analyst. She is frequently quoted on CNBC, Bloomberg, Fox Business and Reuters. Lien has also written for publications like Active Trader, Futures, and SFO magazine. She is the author of the newly updated Day Trading the Currency Market: Technical and Fundamental Strategies to Profit from Market Moves, and the co-author of Millionaire Traders: How Everyday People Are Beating Wall Street at Its Own Game with Boris Schlossberg.

To buy Kathy’s newly updated Day Trading and Swing Trading the Currency Market: Technical and Fundamental Strategies to Profit from Market Moves, click here.