Weekly Chart: Cable vs. 2Y UK – US IR Differential

As for EURUSD and the 10Y interest rate (IR) spread (here) or for USDJPY versus the equity market (TOPIX, see here), the same interesting divergence has been occurring between Cable and the 2Y IR differential. We mentioned in many of our posts that the interest rate differential (either short term 2Y or long term 10Y) has been considered as one of the main drivers of a currency pair for a long time. For instance, in our BEER FX Model, we used the terms-of-trades, inflation and the 10-year interest rates differentials for our cross-sectional study, using the US Dollar as the base country and currency (see post here).

Hence, if you look back over the past few years, there is a significant co-movement between the two times series. As you know, the ST 2Y IR differential reflects the expected announcements from either UK or US policymakers concerning the future path of the target IR set by the central bank. For instance, between summer 2013 (when Governor Carney took office at the BoE) and summer 2014, the 2Y IR differential went up from 0 to 45bps on the back of strong UK fundamentals (fastest growing economy in G7 in 2014) and market participants starting to price in a rate hike as early as Q4 2014 or Q1 2015 according to the short-sterling futures contract (see July 2014 update). The increase of both the 2Y IR differential and the short-sterling futures implied rate brought Cable to its highest level since October 2008 at 1.72 in July 2014. However, both trends reversed that summer with the US Dollar waking up from its LT coma and the UK starting to show some weaknesses in its fundamentals. At that time, we entered a 2Y+ Cable bear market, and if we omit the pound ‘flash crash’ in early October 2016 and set the low at 1.20, Cable experienced a 30-percent depreciation. Therefore, this fall moved the British pound from being a slightly overvalued currency to a clearly undervalued currency if we look at some broad measures such as the real effective exchange rate (REER). According to the REER, the Pound is 15% far away from its 23Y LT average (GBP REER).

If we look at the last quarter of 2017, despite a 50bps drop in the 2Y differential (currently trading at -1.44%), Cable found support slightly below its 100D SMA each time and the pair has shown strong momentum since the beginning of the year. We believe that the strong decrease in the IR differential lately comes from an (over) confident market pricing in three Fed hikes next year (probability of 4 or more rate hikes stands at 9% in 2018). However, we think that this current excitement may slow down in Q1 2018, hence readjust the IR differentials, which is going to be positive for the British pound against the greenback. In our view, the 1.40 level seems reasonable for Cable in the medium term (1-3M), which corresponds to the 38.2% Fibonacci retracement of the 1.20 – 1.72 range.

Chart: GBPUSD vs. 2Y IR differential (blue line, rhs) Source: Reuters Eikon


Purchasing Power Parity (PPP) and Real Exchange Rates (RER)

Abstract: In this article, we introduce the Purchasing Power Parity, a theory that stipulates that in the long run, the exchange rate between two countries should even out so that goods essentially cost the same in both countries. The research organizes as follows. In Section 1, we introduce the PPP theory based on the work of Dornbusch (1985), presenting the absolute and relative versions of PPP. In Section 2, we provide three difference analysis and compare the exchanges of Canada, Britain and Japan  (all vs. USD) against their PPP values using Eurostat-OECD data. Section 3 presents the Real Exchange Rate (RER), a rate which seeks to measure the value of a country’s goods relative to the those of another country at the prevailing exchange rate.

LINK ===> PPP and RER


(PPP Value relative to the US Dollar)

Happy October: End of POMO

As October is the Fed’s POMO – Permanent Open Market Operations – last month (as it is mine in Hambros), we will see how the equity market will deal in a period with no QE. The NY Fed released yesterday its purchase operations for the month of October (as you can see it below), stating that the central bank will buy approximately $10bn worth of Treasury securities on an outright basis.

Starting October 28th (the first day of the next FOMC meeting), the equity bulls will start to rely on fundamentals once again. As we say, will this time be different?


(Source: NY Fed)

The market has switched to a risk-off mode for the past couple of weeks with the S&P 500 struggling to trade above the 2,000 level. As you can see it on the chart below, the index (purple line)  is down 2.2% from its September’s high of 2,018.21 (Sep 19th) and AUD/JPY (black bar) is back below the 96.00 level (down 2% as well) and has been fluctuating within a 100-pip range for the past week.


(Source: Reuters)

Earlier this morning, both Germany and UK released a lower than expected manufacturing PMI, coming in at 49.9 (vs 50.3 expected) and 51.6 respectively (vs 52.5 expected). France reported its budget deficit forecasts for the next few years, and the government sees deficit falling to 4.3% of GDP in 2015 (from 4.4% this year), 3.8% in 2016 and eventually somewhere below  the 3% threshold in 2017 (optimistic?).

EUR/USD was little sold this morning after the macro news (1.2584 is today’s low) and is now trading back above the 1.2600 level. Cable hit its 1.6160 support, the 76.4% Fibo retracement of 1.6050 – 1.6526 (as we reported yesterday) before coming back to 1.6200.


(Source: Reuters)

This afternoon, the market will watch West fundamentals with Mortgage Applications, ISM Mfg PMI and ADP National Employment  in the US and Canadian PMI. I don’t see any major developments in the FX market as the market is now focused on tomorrow’s ECB meeting and Friday’s NFP.