Pound Vs. Euro: Tie Game for Now?

While I’m fondest of analyzing all currencies relative to the Dollar (after all, it’s what I’m most familiar with and is involved in almost half of all forex trades), sometimes its interesting to look at cross rates.
Take the Pound/Euro, for example, arguably one of the most important crosses, and one of a handful that often moves independently of the Dollar. If you chart the performance of this pair over the last two years, however, you can see the distinct lack of volatility. It has fluctuated around an axis of 1.15 GBP/EUR, never straying more than 5% in either direction. In fact, it’s sitting right at this level as I compose this post.

Yesterday, I read some commentary by Boris Schlossberg (whom I interviewed in 2010), Director of Currency Research at GFT. In the title (“Euro and Pound Go Their Separate Ways”), he seemed to suggest that a big move was imminent. Aside from noting that both currencies stand at crossroads, he declined to offer more concrete guidance on the direction of the potential breakout.
At the moment, the markets are gripped by risk aversion, caused by the Mid East political turmoil and the Japanese natural disasters. Once these events run their course and the accompanying market tension subsides, investors will need something else to latch on to. Perhaps the Bank of England (BoE) and European Central Bank (ECB) can fulfill this function, since both are on the verge of hiking their respective benchmark interest rates . Absent any other developments, the timing and speed of such hikes will probably dictate not only how these currencies perform against each other, but also how they perform against the Dollar.
Despite the numerous indications that both have given to the contrary, I don’t think either Central Bank is in a hurry to raise interest rates. Economic growth remains poor, unemployment is high, and inflation is still moderate. Neither is yet at the stage where it can unwind the monetary easing that it put in place at the height of the financial crisis. Moreover, both are wary about the potential impact of rate hikes on their respective currencies (a concern that I am ironically fomenting with this post).
It looks like the BoE will be the first to act. Combined with high energy prices, the bank’s easy monetary policy is putting extraordinary pressure on prices, and it now appears that inflation could reach 5% in 2011. In addition, the BoE voted 6-3 at its last meeting in favor of tightening, which means that a hike probably isn’t too far off. On the other hand, the ECB is talking tough, but it still doesn’t have much of an impetus to act. Inflation is moderate, and besides, the region’s banks remain too dependent on ECB cash for it to serious contemplate being aggressive.
Either way, the interest rate differential probably won’t be great enough to encourage any short-term speculation between the two currencies. In addition, I think investors will continue to look to the Yen and the Dollar for guidance, and we won’t see any significant movement in either direction. [The chart below is based on benchmark lending rates and isn't necessarily applicable for retail forex trading].

This would create two opportunities for investors: Options traders should consider a long straddle, which involves selling a put and call at the same strike price (perhaps 1.15), pocketing the premiums, and praying that the rate doesn’t fluctuate much (since they would be exposed to unlimited risk). In the future, carry traders can also profit from the lack of volatility through a carry trading strategy, perhaps amplified by a little leverage. Be careful, however. Since interest rate differentials are currently so small (The current LIBOR rate disparity is a mere .05%!) and probably won’t widen to more than 1% over the next twelve months, any profits from interest could easily be wiped out by even the smallest adverse exchange rate movements.

Forex Reserve Plan could Harm Pound

Yesterday, UK Chancellor George Osborne announced that his government was ready to begin rebuilding its foreign exchange reserves. Depending on when, how, (or even if) this program is implemented, it could have serious implications for the Pound.
Forex reserve watchers (myself included) were excited by the updated US Treasury report on foreign holdings of US Treasury securities. As the Dollar is the world’s de-facto reserve currency and the US Treasury securities are the asset of choice, the report is basically a rough sketch of both the Dollar’s global popularity and the interventions of foreign Central Banks. Personally, I thought the biggest shocker was not that China’s Treasury holdings are $300 Billion greater than previously believed (with $3 Trillion in reserves, that’s really just a rounding error), but rather that the UK’s holdings declined by 50% in 2010, to a mere $260 Billion.

Given that the Bank of England (BoE) injected more than $500 Billion into the UK money supply in 2010, I suppose that shouldn’t have been much of a revelation. After all, selling US Treasury Securities and using the proceeds to buy British Gilts (sovereign debt) and other financial instruments would enable the BoE to achieve its objective without having to resort to wholesale money printing. In addition, if not for this sleight of hand, UK inflation would probably be even higher.
Still, this is little more than a mere accounting trick, and those funds will probably still need to be withdrawn from the money supply at some point anyway. Whether the BoE burns the proceeds or reinvests them back into foreign instruments is certainly worth pondering, but insofar as it won’t impact inflation, it is a matter of economic policy, and not monetary policy.
As Chancellor Osborn indicated, the UK will probably send these funds back abroad. In addition to providing support for the Dollar (as well as another reason not to be nervous about the upcoming end of the Fed’s QE2), this would seriously weaken the Pound, at a time  that it is already near a 30-year low on a trade-weighted basis. After falling off a cliff in 2009, the Pound recovered against the Dollar in 2010, largely due to the BoE’s shuffling of its foreign exchange reserves. To undo this would certainly risk sending the Pound back towards these depths.

On the one hand, the UK is certainly conscious of this and would act accordingly, perhaps even delaying any foreign exchange reserve accumulation until the Pound strengthens. On the other hand, the BoE is under pressure to fight inflation. It is reluctant to raise interest rates because of the impact it would have on the fragile economic recovery. The same can be said for unwinding its asset purchases. However, if it offset this with purchases of US Treasury securities and other foreign currency assets, it could weaken the Pound and maintain some form of economic stimulus. Especially since the UK has run a sizable trade/current account deficit for as long as anyone can remember, the BoE has both the flexibility/justification it needs to coax the exchange rate down a little bit.
Ultimately, we’ll need more information before we can determine how this will impact the Pound. Still, this is an indication that the GBP/USD might not have much more room to appreciate.

Parity Party

Only last year, the idea that the Australian Dollar would ever reach parity with the USD was laughable. Then, earlier this year, it became plausible. Now, according to an informal poll of analysts, it is not only possible, but likely. AUD bulls should look no further than the rapid surge in commodity prices, which may boost the total value of Australian exports by 20%, including a 30% rise in its commodity exports. In short, the Australian economy has boomed, and inflation is slowly creeping up. The consensus among economists is that the Royal Bank of Australia will leave its benchmark lending rate unchanged at 7.25% for the duration of the year. At the very least, it won’t lower rates, which is all analysts need to believe in order to get behind its currency. Bloomberg News reports:

"There could be some parity parties going on,” said a currency strategist in Sydney at RBC, a unit of Canada’s largest bank. "The RBA…[has] given a green light for the market to push the currency higher."

New President Will Help Dollar

By one measure, the US Dollar has lost 33.8% of its value under President George Bush, its worst performance by far under any one administration. The burgeoning twin deficits, lackluster economic performance, as well as the current environment of stagflation have all contributed to a dramatic and unprecedented loss of confidence in the Dollar. While investors are understandably optimistic about the prospect of a new President, come January, they are ambivalent as to whether it is Barack Obama or instead John McCain that is ultimately elected. Since the Dollar seems to have bottomed out anyway, the new President stands to preside over a recovery of the Dollar. Reuters reports:

"We look at the dollar as a brand and any change from Bush will help benefit the dollar."

AUD: So Much for Parity

The parallels between the Australian Dollar and the Canadian Dollar are remarkable! Both currencies are backed by economies highly dependent on natural resources. Both countries’ Central Banks are considering rate cuts in response to slowing growth. Finally, both currencies have slipped well below parity with the US Dollar. Unlike the Canadian Loonie, the AUD had never quite breached the mythical 1:1 level with the USD. Furthermore, given the deteriorating economic picture in Australia, parity is off the table for a long time.
Demand for Australia’s vast natural resources had begun to taper in response to rising prices, and now that prices have softened, exports are off even more. The Central Bank of Australia is indicating that it considers this drop in demand more of a threat than rising inflation. Accordingly, it will attempt to cushion the blow by lowering rates, perhaps as soon as next month. The Australian Dollar’s status as a beneficiary of the carry trade- because of the lofty 7.25% benchmark interest rate- may soon come to an end. Bloomberg News reports:

Investors have increased bets the central bank will cut borrowing costs. [It] will lower the benchmark rate by 91 basis points, or 0.91 percentage point, in the next 12 months, showed [one index].

Parity Party for the AUD

Is the "parity party" on or off? That is the question on the minds of currency traders following the Australian Dollar. Last week, analysts indicated that the party had been postponed, if not cancelled entirely. This week, there are signs that perhaps some of the bearishness surrounding the AUD is overblown. To be sure, the Australian economy is slowing, and the Central Bank will almost certainly lower interest rates. At the same time, some analysts believe that commodity prices have fallen too far, and will recover in time, as the long-term fundamentals that have underlied their rise still remain in place. Besides, the currency’s losing streak is already the worst since 1980, which suggests investors have gone too far. The most likely scenario is a bumpy 2008 for the currency, followed by a strong 2009. News.com.au reports:

[One analyst] said a recovery in global commodity prices could give the currency a much-needed bounce over the next few months. Citigroup has also forecast that the global markets have turned "too bearish" on commodity prices.

Australia, New Zealand to Lower Rates

I won’t lie; the Forex Blog is admittedly Dollar-centric, in that developments in forex markets are usually assessed relative to their projected impact on the US Dollar. Sometimes, we forget that their are other currency pairs that move irrespective of the Dollar. Take the Australian Dollar and New Zealand Kiwi, for example. As both currencies are backed by high interest rates, they have benefited equally from the carry trade and as a result, they behave quite similarly. Combined with the fact that they are practically neighbors, it’s easy to forget that there are unique circumstances that weigh separately on them.
Over the next 12 months, both countries’ Central Banks are expected to significantly lower their benchmark interest rates as a result of slowing economic growth. However, as New Zealand does not have a large stock of natural resources to depend on in times of economic turmoil, it is projected to lower rates quite sharply, compared to Australia. Accordingly, the Australian Dollar may represent a buying opportunity against the Kiwi in the near-term. Bloomberg News reports:

New Zealand’s dollar is likely to fall 8.7 percent to NZ$1.33 versus Australia’s by year-end as the nation’s economic slowdown accelerates, boosting prospects the RBNZ will lower borrowing costs…according to RBC Capital Markets.