Sterling On the Rocky Road To Parity With Euro. By Nicholas Hastings

Talk of parity between the euro and the pound is on its way back.

The single currency's rally this summer has already lifted it close to GBP0.90 and another surge towards GBP1.00 is likely to emerge now that sterling is being seen as a funding currency.



Add to this, continued hawkish talk by the European Central Bank, suggesting that euro-zone rates may be pushed higher before those in the U.K., and the euro's appeal as a high yielder is likely to increase.

The prospect of the Bank of England keeping interest rates down for longer than anticipated increased this week after the bank's governor Mervyn King warned that bank deposit rates might be reduced further.

His surprise warning came as the U.K. economy showed more and more signs of slowing down again - suggesting that the upturn seen earlier this month isn't sustainable.

Thursday, these fears were driven home by new retail sales figures for August. Not only did sales remain flat, compared with forecasts of a 0.2% increase, but the healthy 0.4% rise in July sales was revised down to just 0.2%.

Roll this up with a continued rise in unemployment and the government's admission that it will need to cut public spending to reign in the public deficit and the outlook for the economy is hardly promising.

As Vicky Redwood, U.K. economist with Capital Economics in London, put it: "With pay growth still slowing and the economic recovery in danger of fading, it would be dangerous to assume that the risk of deflation has passed."

The risk of deflation may not have passed for the euro-zone economy either, given that its recovery is looking just as fragile.

However, it is the more hawkish policy stance being taken by the ECB that is contributing to the euro's appeal at time when investor appetite for higher-yielding asset markets is on the rise.

This dichotomy is being reflected in the three-month LIBOR rates of the two countries. While the rate in the U.K. has fallen to a new record low of 0.59438 this week, the rate for the euro zone is up at 0.72313 - ensuring that the differential is widening in favor of the euro.

As a result, the euro has been pushed up close to GBP0.90 and could be headed back up over 0.95, a level last seen at the turn of the year.

With U.K. officials showing little concern about sterling's decline at this stage - given that the fall will only help the country to increase its exports - and with euro-zone officials remaining happy with the euro's advance so far, investors may find there is little resistance to a further extension of the trend.

Overnight sterling took another sharp hit amid reports that Lloyds Banking Group PLC had failed its latest Financial Services Authorities stress test and been forecd to abandon its plan to withdraw from the government's asset-insurance plan.

Weaker global stock markets also dented risk appetite and weighed on sterling, and the pound will be under scrutiny again around 0830 GMT when the only data on offer Friday hits the wires in the shape of the U.K.'s August public finances.

Around 0645 GMT Friday, the euro had climbed to GBP0.8995 from GBP0.8962 in late New York trade Thursday, while sterling had slipped around one cent to $1.6348 from $1.6445.

The euro is softer at $1.4696 from $1.4740 late Thursday in New York, while the dollar is worth Y91.10 compared with Y91.03.