Bob Munro, Senior Currency Strategist at HiFX comments, "Whilst there is no doubt that the UK economic deterioration is gathering speed, we should note that Sterling is traditionally the market punch bag due to its relative lack of liquidity and ironically, its familiarity to the dominant London market traders. There is also a strong argument to suggest Sterling is now becoming chronically under-valued on any purchasing parity measurement. However, history shows us that this does not mean that markets will automatically buy or sell a currency swiftly back towards this equilibrium measure.
Sterling vs. Dollar
With little between their respective interest rates and their countries' economic prospects, the battle between Sterling and the Dollar is one between two very weak currencies. The woes facing Sterling throughout 2008 have been well chronicled however the Dollar enjoyed a period of strength in the second half of 2008 mainly due to specific technical factors (global investor liquidation / deleveraging and a shortage of Dollars in the money markets).
Munro continues, , "Whilst this period of strengthening for the Dollar may yet have further to run, and we look to the stock and money markets performances in coming months for our guide on this, we do see the Dollar overall as over-valued while Sterling is already starting to look extremely under-valued.
"In the short-term, we have to stick to the market adage ‘never catch a falling dagger' and are advising clients to leave room for further declines. We suggest the 2001 low region of 1.37-1.40 as a potential floor.
"However, the humbled hedge fund community, and even the bank dealing rooms, may be reluctant to trade FX with their previous enthusiasm in 2009, retaining the recent lack of liquidity and, therefore, the recent volatility. Consequently we expect to see relatively wide ranges with 1.65 - 1.70 providing the closest point of reference on the top-side, after the pre-Christmas high of 1.57".
Sterling vs. Euro
The pound consolidated against the Euro around 1.25 between April and November 2008 and offered hope that Sterling had taken its hit early in the credit crunch and would continue to fare relatively well against the single currency. However the escalation of the global economic crisis and the unprecedented UK interest rate cuts again focussed attention upon the relative strength of the UK economy. Foreign exchange traders concluded that our heavy reliance upon the financial services and housing sectors and relatively high levels of personal and Government indebtedness, would mean a deeper and longer recession in the UK. The negative sentiment pressed hard on Sterling as it hit unpredicted lows against the Euro week after week at the end of 2008.
"In the short-term we therefore resort to respecting the underlying trend, meaning Sterling could easily continue to fall against the Euro, with parity an obvious target and 0.95 likely to be a step too far. The current levels of volatility, in every asset class, suggest a recovery towards 1.15 / 1.20 would not be unexpected nor break the underlying trend. Sterling's undervalue may offer some hope, but in the short term the outlook for the pound in 2009 remains gloomy."
