Is Sterling Heading to 1:1 Against the USD?

STERLING CRASH Sterling crashed through the psychologically significant level of 1.1000 on today’s fiscal event. It had initially rallied on the biggest tax cut since the 1980s, but subsequently fell hard as the UK gilt market reacted to the prospect of a heavy new supply slate.

Sterling has been trading off fiscal concerns since early August. Expect this to remain the dominant theme as international investors again consider the right price, both in terms of sterling and gilt yields, to fund the UK’s widening budget deficit.

FX is probably the easiest vehicle to trade UK country risk – given that there is not much liquidity in sovereign credit default swaps for the UK.

CREDIT RATING RISKS The UK's long-term sovereign outlook is currently stable at all three of the rating agencies, S&P (AA), Fitch (AA-) and Moody’s (Aa3). The risk of a possible shift to a negative outlook will come when the ratings are reviewed on 21 October (S&P and Moody’s) and 9 December (Fitch).

Notably as well has been sterling’s disregard for interest rate differentials, where the very aggressive re-pricing of the BoE tightening cycle has provided no support to the pound. This leaves the BoE in a quandary but presumably would have to be even more hawkish if the weaker exchange rate were to damage the UK inflation profile still further.

Unless something can be done to address these fiscal concerns, or the economy shows some surprisingly strong growth data, it looks like investors will continue to shun sterling.

THE FUTURE FX options now price the chances of GBP/USD hitting 1.00 by year-end at 17%. That is up from 6% in late June. Given recent bias for the dollar rally going into over-drive as well, there is a good chance that the market may be underpricing the chances of parity.

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