Euro unlikely to reach parity with sterling, says ING

The euro is unlikely to reach parity against the pound, according to ING Bank, which said the recent rally in the single currency is just an overshoot of more fundamentally-justified levels rather than a sustained trend towards parity.

ING noted that sterling has been an easy target for currency markets on the back of a post-Brexit "economic reality check" and ongoing political anxiety. However, it said this economic divergence story has largely run its course.

"In fact, GBP is beginning to show signs of idiosyncratic selling, similar to previous periods when domestic political risks have flared up," it said.

While EUR/GBP has overshot ING's 0.90 forecast for the third quarter of this year, more quickly than it had expected, the bank highlighted four reasons why a move towards parity looks unlikely at this stage.

It argued that the pound's recent weakness and deviation from short-term fundamentals is now starting to look excessive relative to the near-term political risks at stake.

"This is certainly the case for EUR/GBP, which based on our estimates is trading around 4% above its short-term financial fair value. In contrast, GBP/USD is showing no visible signs of a UK-specific risk premium. We rationalise this as both UK and US political uncertainty offsetting each other in the near-term, making the euro the go-to 'political haven' in currency markets."

In addition, it said political will suggests a Brexit disaster can be avoided. "For GBP's politically-driven weakness to persist and extend all the way towards parity against the EUR, we would argue that 'hard Brexit' risks would need to notch up another gear. In reality, the only way this could occur over the next six months is if we get a nightmare Brexit scenario in October - that is a complete breakdown of UK-EU negotiations."

Instead, ING reckoned the growing consensus within PM May's cabinet over a transitional arrangement means the tail risks of a cliff-edge Brexit are diminishing.

"Progress on securing a transition deal - with both sides providing strong assurances - should help to ease any significant GBP downside bias. However, for this to serve as a catalyst for a rebound in the currency, we would need to see evidence that a reduction in economic uncertainty is in fact spurring a rebound in investment activity."

ING pointed out that sterling is very cheap, with the "very stretched" valuation likely putting a cap on the scale of any further downside. "EUR/GBP is rich by a staggering 20% based on our medium-term Behavioural Equilibrium Exchange Rate (BEER) valuation framework."

Finally, the bank noted that market participants have adjusted to a wait-and-see mode on the Bank of England's stance on rate hikes.

"For short-term domestic rates to move lower, we would need to see evidence of weak consumer activity turning into a hard-landing for the UK economy. Our economists see this as highly unlikely and are not expecting the economy to take a significant turn for the worst."