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Matt Weller, global head of research at City Index, details what to watch for on the way to pound parity.

When was the last time the British Pound traded at parity (1.00) with the US Dollar?

No need to dig your history books; this is not a trick question. The pound has NEVER traded at par with the US dollar.

After spending the entire 1800s at around 5:1, the pound has generally trended lower against the greenback over the past century.

The two currencies came closest together in 1985, when the GBP/USD exchange rate briefly fell below 1.10.

GBP/USD: historical parallels with 1985

Proving that history does not repeat itself but does rhyme, new British Prime Minister Liz Truss’ model Margaret Thatcher was in charge at the time, and the United States passed deep tax cuts under a Republican President (Reagan) a few years earlier. which were beginning to bear fruit on the underlying economy.

Strangely, the United States and the United Kingdom were struggling with high inflation in 1985, although the United States was able to control price pressures before its colonial overseer, as did traders and policymakers. wait this time.

Additionally, oil prices were normalizing after a strong triple-digit rise that led to rationing and calls for price caps.

What factors could lead the pound to parity?

Compared to the US economy, the UK economy is more likely to experience a period of brutal stagflation in the coming quarters.

The BOE recently predicted that the UK economy would experience a prolonged recession and inflation would peak above 13%; Notably, this inflation forecast predates the UK government’s announcement of a household energy price cap plan that could bring inflation closer to the 11% peak in the island nation, but is nevertheless higher than what the United States should achieve.

While it may offset price pressures, the UK government’s energy cap scheme risks further ballooning the UK’s current account deficit.

As a reminder, the current account measures the total value of the goods and services that a country imports compared to the total value of the goods and services that it exports.

After remaining stable in the 1% to 5% of GDP range for decades, the UK current account recently widened to 8% in the first quarter of 2022.

If gas prices continue to rise due to Russia halting deliveries to the European continent, the cost of the energy subsidy program could skyrocket, exposing the government’s balance sheet to significant losses and causing a sharp drop the value of the pound sterling.

Weller GBP-USD

What to watch for on the way to pound parity

Once considered fanciful, there is evidence that FX options traders are at least considering the possibility of a GBP/USD pair.

According to NatWest, current option pricing implies a roughly 25% chance that GBP/USD will hit 1.00 within the next 12 months; similar calculations by Bloomberg put the implied probability closer to 20%.

As noted above, a continued rise in energy prices could accelerate the outlook, as could stubbornly high inflation or a deep recession on the European continent.

Technically speaking, GBP/USD is currently testing its COVID lows near 1.1400, the last previous support level until 1985 closer to 1.0500.

While still not necessarily the most likely path, a break below the 1985 lows would truly put parity in play for the first time in the 200+ year history of the GBP/USD exchange rate.

Expectations of a 100 basis point hike at the Fed are overblown

The Federal Reserve’s September policy decisions are due on Wednesday the 21st. Weller says he doesn’t think the Fed will be panicked by a 100 basis point rate hike:

It seems like ages ago, but this time last month traders thought the Fed was more likely to raise interest rates by just 50 basis points (0.50%) during its September monetary policy meeting.

However, after a hawkish speech from Fed Chairman Powell in Jackson Hole, another strong NFP report and a much warmer than expected CPI report, the market has completely ruled out any possibility of a simple 50 basis point rate hike. and even started pricing an outside chance of a full 100 basis point (1.00%) hike.

In our view, the possibility of a 100 basis point rate hike is overstated.

Lost amid traders’ hesitation over the Fed’s clear focus on fighting inflation and the warmer-than-expected CPI reading is the fact that inflation continues to decline relatively sharply.

After all, the year-over-year CPI inflation rate has fallen from 9.1% to 8.5% to 8.3% in the past two months.

While the Fed would certainly have preferred to see a rate closer to 8.0% last month, other measures of inflation are clearly falling rapidly, suggesting the warmer-than-expected CPI reading could be an outlier. .

For example, the recently released New York Fed survey showed that one-year inflation expectations had fallen to 5.7% (from 6.2%) previously, and that average inflation expectations over three years of the survey fell from 3.2% to 2.8%, within earshot. of the Fed’s long-term objective close to 2%.

dollar index

Above: “Going long the US dollar remains the most obvious trade in the forex market” – Weller.

In other words, there is no evidence that we are entering a self-fulfilling cycle of rising prices; on the contrary, the evidence suggests that consumers and businesses expect pricing pressures to continue to ease over the coming quarters.

Instead of pointing to a 100 basis point rate hike this month, stubborn inflation readings suggest the central bank may be forced to raise interest rates for longer, perhaps until first half of 2023, rather than suspending the current tightening cycle at the end of this year.

A month ago, traders were pricing the peak interest rate for this cycle around 4.00% in January; now the market expects rates to peak closer to 4.50-4.75% in the second quarter of 2023.

Notably, this meeting will provide an update to the Summary of Economic Projections (SEP), including the infamous “dot plot” of Fed members’ interest rate expectations.

Traders will be eager to see when and where Federal Reserve policymakers see this tightening cycle ending.

Finally, the central bank continues to ramp up its quantitative tightening (QT) program to reduce its balance sheet, so any comments on how Jerome Powell and Company sees the development could also move markets.

Going long the US dollar remains the most obvious trade in the forex market (although that doesn’t necessarily mean it will work!). Unsurprisingly, the US Dollar Index continues to find support at its rising 50-day EMA, keeping the bias in favor of the bulls.

As of this writing, the index is testing the 78.6% Fibonacci retracement of its big 2001-2008 slide near 110.25, but if the Fed proves more hawkish than expected, a breakout and a close above this area could target 112.00 or higher in October. .