As the euro breaches parity against the dollar, how low will sterling go?

After a brief respite in late July and early August, the US dollar has continued to march higher, reaching its strongest level against a basket of its trading partner currencies in two decades. While the Japanese yen has been the main casualty of this dollar strength, the euro breached the psychological barrier of parity with the greenback last month, the first time this has happened since 2002.  

There are two main reasons for the dollar’s strength this year: interest rate differentials and the growth outlook.  On interest rates, the Federal Reserve has been far more aggressive in raising interest rates than other developed market central banks, hiking by 225bp this year (to 2.5%) compared with the European Central Bank’s 50bp (to zero) and the Bank of England’s 150bp (to 1.75%).

Since Jerome Powell’s speech at the Jackson Hole symposium in late August, the market has repriced expectations for US rates as Mr Powell and several Fed presidents have reiterated the Fed’s commitment to bringing inflation back down to the target 2% level and indicating that this will require monetary policy to remain tight “for some time”. This has brought the market more in line with our own forecasts for the Fed Funds rate to rise to 4% by the end of this year, which has contributed to the equity market selloff over the last week as well as the rebound in the dollar.

With respect to the growth outlook, recent data suggests that the Fed has scope to tighten monetary policy further as the economy appears to be in good shape despite the rate hikes to date. Survey data shows the US manufacturing sector expanded again in August, and the labour market also remains very strong with 315k jobs added in August even as the unemployment rate ticked up slightly to 3.7%. 

In contrast, the outlook for the Eurozone economy, and that of the UK, is relatively bleak. Manufacturing PMIs were in contraction territory in August and the threat of energy shortages over the winter months adds to downside risks to growth.

Inflation in the Eurozone reached a new all-time high of 9.1% in August according to preliminary estimates.  As a result, ECB policy makers have sounded increasingly hawkish and are likely to raise rates by at least 50bp at their meeting this week, with a high probability of a 75bp hike and additional hikes likely in October. Moreover, while tighter monetary policy will curb demand driven inflationary pressures, it also increases recession risks in the Eurozone, particularly if it is coupled with energy rationing for industry over the winter, limiting the scope of the ECB to raise rates more aggressively. On balance, we expect the interest rate differential with the US will remain wide, keeping the euro under pressure

The British pound has also weakened against the dollar in recent weeks, falling below the March 2020 level to reach levels last seen in the mid-1980s. There has been increased talk of sterling reaching parity with the dollar in the coming months as the outlook for the UK economy continues to deteriorate. Households will face an 80% increase in their energy costs from October, with further price increases likely when the energy price cap is adjusted again in January 2023, pushing already high inflation ever higher.

Indeed inflation expectations in the UK have continued to drift higher and firms now expect wage growth of 5.5% in the year ahead, well above what is consistent with the BoE’s 2% target. All of this suggests the Bank of England is likely to raise the bank rate by 50bp again in September, even as survey data points to declining manufacturing output and the British Chamber of Commerce believes the economy is already in recession. 

Uncertainty over fiscal policy under a new British prime minister has probably also contributed to the recent sell-off in sterling, and is weighing on investor appetite for UK assets. Liz Truss, the favourite to win the leadership contest, has campaigned on a platform of tax cuts that would result in a wider budget deficit but without the benefit of targeting the relief to lower income households, which are most affected by higher utility costs.

Lower taxes and increased spending could further fuel inflation, increasing pressure on the Bank of England rates to raise rates further and faster than might otherwise have been the case. The swap market is now pricing in a further percentage point in rate hikes by the Bank of England in the fourth quarter, which would take the Bank Rate to 3.5% by the end of this year, raising borrowing costs for households. Gilt yields have also increased to the highest levels in almost a decade, raising the cost of government borrowing to finance a bigger fiscal deficit.

Markets have been further unsettled by Mrs Truss’s desire to review the Bank of England’s mandate and her stance on the Northern Ireland Protocol, which could further disrupt trade with the EU.

It is possible that these proposed policies are moderated or scrapped once a new prime minister and cabinet is in place, which could provide some support to the pound in the near term. However, the challenges facing the UK economy remain significant and the risks to sterling remain on the downside for now.

A version of this article was published in The National on 5 September.