A History of the British Pound

In today’s article, we will provide a recap of the history of the British Pound. According to the yearly BIS Foreign Exchange Turnover published in April 2016, the British pound is part of the G10 currencies and is the fourth most ‘traded’ currency with a daily average of 649 billion Dollars. Its percentage share of average daily turnover stands at 12.8%, and its two main ‘counterparties’ are the US Dollar ($470bn) and the Euro ($100bn).

Note that the exchange rate $/£ [or USD/GBP] is also called Cable, a term that derives from the advent of the telegraph in the mid-1800s. Transactions between the British pound and the US Dollar were executed via a Transatlantic Cable, and the first exchange rate was published in The Times on August 10th 1866.

This article will be split in two parts; the first one [briefly] retraces the origin and the history of Sterling until the End of the Bretton Woods system in 1971, and the second part explains the trends and reversals of Cable in addition to stating what I believe were the main drivers of the currency pair (from 1971 to today).

I. Origin and History of the Sterling pound between the mid-700s and the end of the Bretton Woods system (1971)

A. Quick history recap

Considered to be the oldest living currency in the world, the pound is 1,200 years old and was born in the latter half of the 8th Century, when silver pennies were the main currency in the Anglo-Saxon Kingdoms. The name [Sterling] pound (or Livre sterling in French) comes from the Latin word Libra Pondo, which means pound weight.

Back in the 8th century, 240 silver pennies represented one pound of weight and it was not until 1489 (under Henry VII) that appeared higher denominated coins with the first pound coin. Then, paper notes began to circulate after the establishment of the Bank of England in 1694, the world’s second oldest central bank (after the Sveriges Riksbank, the Swedish central bank). The Bank of England started as a ‘private company’ with the immediate purpose of raising funds for King William III’s war against France (issuing notes in return for deposits).

Even though there is an infinite amount of [inspiring] work on the Bank of England and the British currency, I am going to move directly to the 19th century when the British pound became the world’s reserve currency for a century after the Napoleon’s defeat at Waterloo in June 1815 (Foreign Exchange Reserves, Image 1). Great Britain arose as the leading exporter of manufactured goods and services and the largest importer of food and industrial raw materials. Between the mid-1800s and the outbreak of WWI in 1914, 60 percent of the global trade was invoices and settled in British pound (B. Eichengreen, 2005). London became the world’s financial capital in the late 19th century and the export of capital was a major based for the British economy until 1914. As foreign governments were seeking to borrow in sterling, British financial institutions established branches in the colonies and colonial banks opened offices in London. In 1913, Sterling’s share in the Official Foreign Exchange Assets stood at 48%, above Francs (31%) and Marks (15%) according to Lindert’s calculation (1969).

B. WWI outbreak and its consequence on the UK (and Sterling)

Although the US economy surpassed the British economy in size [in real terms] in 1872 (Gheary-Kamis, 1990), the important switch occurred in the early 1910s:

  • the US became an net creditor while the became a net debtor
  • and more importantly, the Federal Reserve was established in 1913 (December 23rd), with the enactment of the Federal Reserve Act

At the outbreak of WWI, the gold standard was suspended and restrictions were placed on the export of gold, which obviously had a negative impact on the British pound (vis-à-vis the US Dollar) as we can see it on Chart 2a. Prior to and during most of the 19th century, one pound was roughly worth 5 US Dollar (Chart 2b), with some ‘turbulence’ in 1860s due to the American Civil War.

Severe inflation (20%+), lack of demand, a high unemployment rate (above 10%) in addition to a 25-percent drop in economic output between 1918 and 1921 launched the Great Depression in United Kingdom at the end of WWI, which last for two decades. The pound first plummeted from $4.70 to $3.50 during that 3-year period before swinging back to its prewar levels (at $4.87).

C. ‘In between’ the Two Wars

The pound ‘rebound’ in the early 1920s (Chart 2a) could be explained by the political desire to maintain the value of Sterling at a ‘high’ rate (i.e. prewar levels) to give Britain an [economic] successful image to the rest of the World. In order achieve that, the UK had to run contractionary fiscal and monetary policy (Image 2a), which increased interest rate differentials (i.e. attracted savings in Britain) and pushed the UK inflation rate below the US one. As the US inflation rate was already very low at that time, the UK was experiencing deflation at that time (Image 2b).

Then, in 1925, Britain re-adopted a form of Gold Standard where the exchange rate was determined by the relative values of gold in the two countries, with a fixing at 4.86 US Dollar per unit of Pound. This Gold Standard ‘return’ was considered to be disastrous (Churchill’s biggest mistake as he was serving as the Chancellor of the Exchequer at that time), as it resulted in persistent deflation, high unemployment rate that led to the General Miners’ Strike of 1926. The UK was stuck in the debt vicious spiral; running a contractionary fiscal and monetary policy during a deflationary recession was increasing both the amount of UK debt in real terms and its burden (high interest rate increased the cost of borrowing). This led to a Balance of Payments issue, and led to a run on the pound. On the top of that, the Wall Street Crash and the beginning of the Great Depression put the British economy under intense pressure, which eventually came off the Gold Standard in September of 1931. In the year that followed, the British pound dropped to lower lows to around 3.25 against the US Dollar. However, as Barry Eichengreen noted in his paper Fetters of Gold and Paper, countries that came off the Gold Standard early (i.e. UK) did better [or less worse] than the countries that remained on it for longer (i.e. US). After a 3-year [1930-1932] pronounced deflationary period in the US (Image 3), rapidly rising prices in the summer of 1933 (after the US went eventually off the gold standard on June 5th 1933) eased the ‘strain’ on other countries and kicked off the dollar depreciation. The British pound rapidly recovered its losses and surged to a new high of $5 by 1934 (Chart 2a). The pound remained afloat and oscillated at around $5 until 1939 and the outbreak of WWII. This depreciation (which brought back the British pound to its low of 3.25 against the greenback) was mainly due to uncertainty around the outcome of the war, as fundamentals were expected to deteriorate very quickly (output collapse, a rise in inflation) indebting the British economy even more.

D. World War II and Bretton Woods period

In 1940, an agreement between the US and UK pegged the pound to the greenback at a rate of $4.03 per unit of pound. This exchange rate remained fixed during WWII and was maintained at the start of the Bretton Woods system (Chart 2a). British emerged from WWII with an unprecedented debt of nearly 250 percent as a share of GDP (most of it owned to the US) with ‘strong’ currency, a [much] less dominant market in terms of competitiveness and a degrading balance of payments (Hirsch, 1965). Despite the soft-loan agreement (a 3.75 billion-dollar loan to the UK by the US negotiated by JM Keynes at a low 2% interest rate with repayment over fifty years) to support British overseas expenditure post WWII, the British pound remained under intense pressure. Chancellor of the Exchequer Sir Stafford Cripps eventually announced a 30-percent pound devaluation from $4.03 to $2.80 in September 1949.

However, the devaluation was not enough as the following two decades were characterised by persistent balance of payment problems and led to the Sterling crisis of 1964-1967. The UK was forced to seek assistance from the Bank of International Settlement and the IMF more than once. Despite persistent current account deficits and a deteriorating balance of payments in 1964-1965 (Image 4), UK officials didn’t react (i.e. devalue) as they argued that devaluation would severely strain Britain’s relations with other countries when the main holders of sterling would begin to withdraw their balances from London and also threaten the international monetary system (Bordo & al., 2009). The pound weakness persisted in 1966 and 1967, covered by lines of credit received by other central banks (i.e. swaps with the NY Fed) and the IMF. But the government eventually ceded and PM Harold Wilson announced that the pound would be devalued from $2.80 to $2.40 on Saturday 18 November 1967. It then remained at that level until end of Bretton Woods.

II. The trends and reversals of Cable since the End of the Bretton Wood System in 1971

Note that all the periods and important events are marked in Chart 1 (see end of article).

A. The Nixon 1971 Shock and Smithsonian Agreements (1971 – 1973)

In addition to signing the Smithsonian agreement at the December 1971 G10 meeting, where the US pledged to peg the dollar at $38 an ounce (instead of $35 during BW) with 2.25% trading bands (instead of 1 percent), the UK also agreed to appreciate their currency against the US Dollar. The pound was worth $2.65 by the end of the first quarter 1972.

B. 1973 – 1976: a rough start

However, it did not take too long for troubles to ‘come back’ in the UK and the pound experienced a series of speculative attacks in the mid-1970s. Cable hit a low of $1.5875 in the last quarter of 1976 and the UK had to call the IMF to counter persistent runs on Sterling. This loan was followed by a series of austerity measures, which helped reduce inflation and improve the economic activity, hence boosting the pound in the second half of the 1970s.

C. 1976 – 1980: US inflation and the Dollar depreciation

The positive UK-US carry trade due to low interest rate run by the Fed in the mid-1970s (as a response to the post first-oil shock recession) gave birth to a four-year shining period for Cable, which recovered by 54% to hit a high of $2.45 in the last quarter of 1980.

D. The V shape of the 1980s

I like to describe the 1980s as a V-shape curve for Cable as there were two major trends during that period. As a result of the second oil shock caused by the Shah revolution in Iran in 1979, oil prices doubled in the following year leading to a sharp increase in inflation in the US in 1979-1980 (peaked at 15% in the first quarter of 1980). In order to reign in the double-digit inflation, Fed chairman Volcker reacted immediately by orchestrating a series of interest rate hikes that levitated the Fed Funds target rate from 10% to nearly 20%. Even though the dramatic increase in interest rates caused a painful recession and a surge in unemployment rate (11%) in the US, it eventually led to international capital inflows as high [real] interest rates became attractive to foreign investment. What followed was a severe appreciation of the US dollar vis-à-vis the major currencies; Cable lost more than half of its value and hit a historical low of $1.0520 in the first quarter of 1985 (Chart 1). This Dollar Rise under the Reagan administration was a problem for the US economy as the current account fell into substantial and persistent deficit (Image 5a). In addition, the US was also running large budget deficit of 5%+ during the same period (Image 5b), which put the country in a twin deficits anomaly and caused considerable difficulties for the American industry (i.e. car producers, engineering and tech companies…).

Therefore, in order to re-boost the US economy, the Plaza Agreement was signed in New York on September 22nd 1985 and France, Japan, West Germany and the United Kingdom agreed to depreciate the US Dollar by intervening in the currency markets. This decision created a secular change in the financial market and immediately reversed the 5-year bull momentum on the US Dollar. The Pound reacted and appreciated roughly 80 percent in the following three years. I am not sure if the [financial] sentence ‘Don’t fight the central banks’ came from this decade, but I think it is a good example to show you how much effect a central bank cohort move can have on the market.

E. 1988 – 1992: the volatile period

We saw a consolidation between 1988 and 1989 to $1.51 after Margaret Thatcher’s Chancellor of the Exchequer Lord Lawson decided to unofficially peg the British pound to the German Mark (UK wasn’t in the Exchange Rate Mechanism yet (Image 8, green period). This caused inflation, a credit bubble and a property boom that eventually crashed in 1989-1990 followed by a recession.

Cable started to recover in the first quarter of 1990 as the interest rate differential increased preference for the British pound (Chart 3). In the middle of 1989, the Federal Reserve began to run a loose monetary policy in order to boost the US economy weakened by the Savings and Loan crisis of the 1980s and 1990s. Fed’s chair Alan Greenspan decreased the Fed Funds rate from 9.75% in March 1989 to 3% in September 1992 to boost productivity (Chart 3). Cable double topped at [perfect] resistance $2.00, a first time in Q1 1991 and a second time in Q3 1992.

It is also important to note that during that time, the Conservative government (Third Thatcher ministry) decided to join the Exchange Rate Mechanism on October 8th 1990 (Image 8, grey period), with the pound set at DM2.95.

16 September 1992: Black Wednesday and ERM exit (Source: Inside the House of Money)

Also called [another] Sterling crisis, the British government was forced to withdraw the Pound Sterling from the ERM on that day, sending the pound into a free fall. Cable tumbled by 30% from [Q3 92] peak to [Q1 93] trough. But what really happened then?

As we mentioned before, the UK tardily joined the ERM in 1990 at a central parity rate of DM2.95 and a trading range band of +/- 6 percent. The exchange rate was arguable judge too strong by many economists at that time, therefore the overvalued currency in addition to high interest rates and falling house prices led the country into a recession in 1991. It became difficult for UK officials to maintain the value of the Pound at around its target against the Deutsch Mark. Meanwhile, Germany was suffering inflationary effects from the 1989-1990 Unification, which led to high interest rates. Therefore, despite a recession, the UK was ‘forced’ to keep interest rates high (10% in September) to maintain the currency regime. Speculation began and global macro traders (i.e. Soros) increasingly sold pounds against the Deutsche Mark. To discourage speculation, UK Chancellor Lamont increased rates to 12% on September 16th with a promise to raise them again to 15%. However, traders continued to sell British pounds, as they knew that increasing rates to defend a currency during a recession is an unsustainable policy.

Eventually, on 16 September 1992, the UK government announced that it would no longer defend the trading band and withdrew the pound of the ERM system. The pound lost 15 percent of its value against the DM in the following weeks and traded as low as DM2.16 in 1995.

Even though we usually do our analysis of a specific currency vis-à-vis the US Dollar, I thought it was important to mention the presence of the Deutsch Mark as it explained Cable’s depreciation in 1992 and 1993.

F. 1993 – 1998: the Dull period with shy Sterling Gains

After the ERM exit, it was dull period for the USD/GBP, Cable oscillated around $1.60 with a shy little upward trend (i.e. shy GBP gains) helped by the small interest rate differentials and a series of trade balance surpluses. It looks like the $1.70 psychological resistance was hard to break between 1996 and 1998 and the Pound traded within a ‘tight’ 10-figure range during these years.

One important event during that period was that the Monetary Policy Committee was given operational responsibility for setting interest rates in 1997 with one [only] mandate: maintain a 2-percent inflation rate in the long run. Traditionally, the Treasury set interest rates.

G. 1999 – 2002: The Sterling Depreciation

 As we saw for the Euro (and the Yen at a lesser extent), the turn of the century was marked by a Dollar appreciation between 1999 and 2002. Cable lost a bit of steam during that period and spent a lot of time flirting with the $1.40 support in 2000 and 2001 (it even hit a low of $1.37 in Q2 2001). I have not found any supportive literature to explain this downward bias, but it is not absurd to assume that some of the dollar strength came from a surge in the equity market capitalization in the US – with the Tech Boom – and potentially a higher productivity than in the United Kingdom.

H. The 2002 – 2008 GBP appreciation (or US Dollar depreciation)

The US Dollar started to tumble in late 2001 / early 2002, which was the beginning of a 6-year bull period for Cable. The exchange rate went north 50% and reached a high of $2.11 in the last quarter of 2007 (with a small consolidation in 2005). The (inflation-adjusted) trade-weighted dollar exchange rate (i.e. see REER) steadily depreciated, falling by roughly 25 percent (Image 6). During that period, US was printing persistent twin deficits: Current Account deficits print a high of 6 percent in 2006 (Image 7a) while Budget deficits were ranging between 2 and 3.5 percent as a share of GDP (Image 7b). In addition, the Fed decreased interest rates to 1.75% after the 9/11 attacks and then to 1 percent in 2003, helping the government to roll its debt at lower costs and finance the Iraq War (total cost to the United States was at 3 trillion USD according to Stiglitz and Bilmes, 2010).

I. 2008: Financial Crisis and the Risk-Off aversion

The British pound saw a massive depreciation in 2008 due to the risk-off sentiment and the sudden demand for Dollars; Cable tumbled 36%+ from [Q4 2007] peak of $2.11 to [Q1 2009] trough of $1.35. In the early 21th century, Sterling had lost its reserve currency for a long time, so when asset prices took a massive hit in 2007-2008 the pound did too. The two currencies that acted as ‘strong’ safe-havens were the US Dollar and the Japanese Yen. This raised an interesting debate on whether countries should have huge amount of debt (denominated in their local currency) in order to have a currency that acts as a safe-haven in harsh period. When you think about it, the two safe-havens are the currencies of the two most indebted nations ($20tr for the US and $11tr for Japan, as of today).

The UK was sharply impacted by the crisis; to give you an idea, the pound’s [36-percent] fall vis-à-vis the US Dollar wasn’t even enough to make up for weakening foreign demand. It took the country’s economy 6 years to come back to its pre-crisis level (summer 2014, ONS), with a debt-to-GDP ratio that soared from 51% in 2008 to 89% in 2014.

Bank of England’s answer: Like many other central banks, the BoE slashed rates from 5 percent in the beginning of 2008 to 0.5% in Q1 2009 (the lowest since the BoE establishment in 1694). In addition, the Bank of England press the QE bottom like in the US and created £375bn of new money between 2009 and 2012.

The series of measures adopted by central bankers brought back interest in the Sterling pound, considered to be ‘cheap’ or undervalued relative to its peers. Cable regained 50% of its value in three quarters and hit a high of $1.71 during the third quarter of 2009; however, the recovery wasn’t very long as the Sovereign debt crisis emerged in Europe (at that time is was Greece) and impacted the British economy (and its currency) as well.

J. 2011 – summer 2013: the other dull period

Bizarrely, the British pound wasn’t affected too much during the [second] EZ sovereign debt crisis between Q3 2011 and mid-2012. For almost two-and-a-half years, Cable traded around $1.50-$1.60 with pressure on the downside in the beginning of 2013. The pressure came after it lost its top AAA credit rating for the first time since 1978 on expectations that growth would ‘remain sluggish over the next few years’. At that time, traders were starting to predict that Cable would retest its 1.40-1.4250 support range as the Pound was clearly not a hot currency in the beginning of 2013. In addition, investors were also starting to look at the Euro’s momentum after the buy-on-dips that followed Draghi’s ‘Whatever it takes’ in July 2012.

Despite the UK weakness, the British pound didn’t fall to further levels as it was ‘saved’ by a dovish Fed and a US Dollar in the coma. In the last quarter of 2012, Bernanke announced a further round of QE with monthly purchases totalling $85bn (of Treasuries and MBS) in order to boost productivity. This prevented the British pound of depreciating too much and raise interest in the cheap Euro at that time.

K. August 2013: New BoE Governor Mark Carney took office and the Pound experienced a fantastic year

In the summer of 2013, Marc Carney left the Bank of Canada to take over Mervyn King’s place as the new Governor of the Bank of England. Then, what followed was a series of good news and positive fundamentals in the UK; the British pound switched from the no-interest status to traders’ favourite currency (with the Euro, there were the market’s Darlings). Cable soared from its $1.48 lows to hit a 6-year high of $1.72 with market participants pricing in a sooner interest rate hike. Cable’s good driver of that one-year bull period was the increase in implied rates [looking at the short-sterling futures contract]. Moreover, Britain was the fastest-growing major economy in 2014, printing an annual growth of 2.9% (surpassing the US and its 2.4%).

L. Summer 2014: the Dollar wake-up and the start of a Bear currency market for the Pound

As I already wrote it in a previous post on the UK, the last positive words on the British economy came out of Carney’s mouth during a speech he gave at the Mansion House on June 12th 2014 (the same night of the kick-start of the World Cup in Brazil). He said that the UK was on a positive momentum (i.e. fundamentals were good) and hinted that the Bank of England may rise rates sooner than the market expected. At that time, I remember that the futures market was pricing in a 25bps hike by the end of Q4 2014.

However, everything vanished a few weeks later and more and more participants were starting to notice that the British pound was showing signs of ‘fatigue’ and that a consolidation was coming. In addition, May 2014 was also the announcement of the ‘Euro’s Death’ and that the single currency expected depreciation may spur an overall Dollar strength. And it happened… According to the DXY index, the Dollar strengthen by 25 percent against its main trading partners between July 2014 and March 2015. Cable tumbled from a $1.72 to $1.4635 during that same period.

In early 2015, most of the market participants was pricing in another 15 to 20 percent increase in the Dollar on expectations of the Fed starting a tightening cycle (taking the two previous Dollar Rally that we described earlier as empirical data: the Reagan Rally in the beginning of the 1980s and the Clinton Rally that occurred in the late 1990s).

2016: The Brexit effect and monetary policy divergence

After a brief pause in 2015 as the Fed halted its tightening cycle [due to the sharp sell-off that occurred in the beginning of 2016], Cable continued its bear market against the US Dollar in 2016 on speculation of a Brexit Yes vote first (in favour of leaving the EU), and then on the concretisation of the Yes vote (52% in favour of Brexit) following the referendum held on June 23rd. The pound traded below the 1.20 level against the greenback after the announcement, its lowest level in 21 years, and remains currently under pressure as Brexit uncertainty will continue until Article 50 gets triggered.

BoE answers to Brexit

After four years of status quo [and hints of potential rate hikes], the Bank of England announced a new round of QE in August last year targeting £60bn of monthly purchases (of which £10bn of corporate debt) and cut its Official Bank rate by 25bps to 0.25%. With the Fed now [seriously] reconsidering starting a tightening cycle after a first hike last month and three potential rate increase in 2017 (DotPlot Gradual Path), the monetary policy divergence between the US and UK and the political uncertainty in Europe (and UK) will weigh on the pound in the near future.

Chart 1. GBPUSD historical monthly candlesticks since 1971 (Source: Bloomberg)

gbpcandle

Chart 2a. Cable historical rate 1915 – 2013 

GBPUSDHis.gif

Chart 2b. Cable historical rate since 1791

HistoryPound.JPG

Chart 3. UK Official Bank Rate (Red Line) versus US Fed Funds Rate (White Line)

RatesUSUK.JPG

Image 1. Reserve currency status (Source: JP Morgan)

ReserveCurrency.png

Image 2a. UK Budget deficit in the 1920s (Source: ONS)

UK Budget 1920s.png

Image 2b. UK Inflation Rate in the 1920s (Source: ONS)

UK Inf.png

Image 2c. UK Unemployment Rate in the 1920s (Source: ONS)

UK Unem.png

Image 3. US Annual Inflation in 1930-1939 (Source: BLS)

Annual Inflation US.jpg

Image 4. UK Current Account in the 1960s (Source: Trading Economics)

UKCurrentAccount.JPG

Image 5a. US Current Account in the 1980s (Source: Trading Economics)

USCurrentAccount.JPG

Image 5b. US Budget Deficits in the 1980s (Source: Trading Economics)

USBudget.JPG

Image 6. US Dollar REER (Source: OECD)

USRealDollar.JPG

Image 7a. US Current Account in the 2000s (Source: Trading Economics)

CurrentAccount2000.JPG

Image 7b. US Budget Deficits in the 2000s (Source: Trading Economics)

BudgetDeficit2000.JPG

Image 8. Exchange-rate regimes for EU members starting 1979 (Source: Wikipedia)

Retracing the US Dollar Q4 rise…

An important topic that has been making the headline over the past few weeks is the new surge of the US Dollar (vis-à-vis the major currencies) in the last quarter of 2016. Since its Obama Rise peak that occurred in mid-March 2015 (after a 25% appreciation), the US Dollar has been ranging against most of the major currencies (except the British pound due to political uncertainty and post-Brexit effect in June, and more recently the Mexican peso). The main reason for that long period of stagnation, in my opinion, was a shift in expectations of monetary policy in the US. After the Fed stepped out of the Bond Market (on October 28th 2014), market’s participants have been mainly focusing on the short-end of the curve, questioning themselves if the Fed was going to start a tightening monetary policy cycle. We saw a hike in December 2015 (25bps), which was immediately halted due to the market sell-off that followed afterwards (13% drawdown in US equities, 20% in Europe and Japan…). Therefore, the implied probability of a second hike in 2016 crashed, which was confirmed by the 7 FOMC meetings that followed (i.e. status quo).

Then, interest in the US Dollar started to emerge again in Q4 2016; the greenback experienced a 8%+ appreciation between October 1st and its December high of 13.65 (28th) according to the DXY index (Chart 1). There are a number of explanations to that recent surge: market was gradually pricing in a rate hike for the December meeting, political uncertainty rising in Europe or Infinite QE in Japan to protect the yield curve. All these stories make sense to explain the Dollar appreciation, therefore let’s retrace the important events that occurred in the last quarter of 2016.

Chart 1. US Dollar index in 2015-2016 (Source: Bloomberg)

usdollarhis

  1. Higher inflation and a positive post-Trump effect

First of all, the rebound in oil prices relieved pressure on energy-related companies [that have been falling one by one, applying to Chapter 11 bankruptcy] and had a positive effect on expected inflation. The price of a barrel has doubled since its February’s low of $26 and is currently trading slightly below $54 (Chart 2, red line) and obviously relieved US policymakers’ inflation anxiety. The 5Y5Y inflation swap forward (Chart 2, white line) stands now at 2.42%, higher than the 1.80% recorded last June. As a consequence, US long-term yields followed the move and the 10-year Treasury yield surged from a low of 1.36% reached in July last year to 2.44% today. With the unemployment rate below 5% and a Q3 GDP growth of 3.5% (annual QoQ), it seems inflation had been the main concern of the Fed’s officials in order to start tightening [again].

Therefore, on December 14th, US policymakers decide to raise the federal funds rate by 25bps to 0.5%-0.75% [and the discount rate from 1% to 1.25%], repeating a gradual policy path plan with three potential hikes in 2017. Even though it was considered to be the most ‘priced in’ hike of any Fed meeting ever, it pushed the implied rates to the upside with the current OIS (Chart 3, purple line) trading almost 1 percent above the OIS at the September meeting (Chart 3, red line). This change in implied rates was reflected in the Dollar appreciation.

Chart 2. US inflation overlaid with Oil Prices and US 10-year yield (Source: Bloomberg)

inflationus

Chart 3. Fed’s dot plot and implied rates (Source: Bloomberg)

FedPlot.JPG

I wasn’t very surprised when the Fed officials announced the rate hike, however I was wondering if we would have seen such optimism if equity markets ‘followed’ the global bond sell-off after the election (Trump effect). The positive US equity market reaction to Trump’s victory also comforted US policymakers for the December’s hike; I strongly believe that the decision would have been much harder if they had to deal with a sudden equity sell-off. Instead, the SP500 reached new record highs (2,277) last months.

One explanation of this development is based on investors’ expectation of an expansionary fiscal policy that will boost economic growth and inflation in the future, which are usually positive news for equities and negative news for bonds in theory (see Four Quadrants matrix – image 1).

Image 1. The ‘Four Quadrants’ framework (Source: Gavekal Research)

  Quandrant.png

   2. Political uncertainty rising in Europe, the rigger of many ‘forgotten’ problems

A popular trade that was running in the last quarter of 2016 was to be long the Italian-German 10-year spread ahead of the Italian referendum that occurred on December 4th. Market was pricing a potential rejection (55% chance), leading to an increase in political uncertainty in Europe, rising spreads between periphery and core and weakening the Euro.

If we look at Chart 4, we can see that the spike in the Italian 10-year yield (Chart 4, white line) could explain the Euro weakness (hence, USD strength). While the 10-year yield increased from 1.20% to 2.20% in two months (October and November), EURUSD (Chart 4, red line, inverted) went down 7 figures and reached a new low of 1.0350 post-referendum (59.1% of voters rejected the reform bill, which was followed immediately by PM Renzi’s resignation).

Even though yields have been decreasing over the past month (the 10-year now standing at 1.73%), political uncertainty could be the trigger of the two ‘delayed’  and ‘forgotten’ issues [or Black Swans] in Europe: the weak banking system and the Sovereign debt crisis. Not only Italy (in this case) cannot survive with higher yields (the country has 2.34 trillion EUR of outstanding debt – 132.6% of GDP – which needs to be rolled with low yields), but a sell-off in equities will increase the percentage of NPLs and potentially forced their banks to bail-in their depositors. The failure of Monte Paschi di Siena’s plan to raise 5-billion euros in capital from the market was ‘solved’ by a Nationalization (the bank’s third bailout). It was announced that the government will own at least 75% of the common equity after the bank is nationalized, a rescue that will cost the Italian government (i.e. taxpayers) about 6.6bn Euros according to the ECB (4.6bn Euros are needed to meet capital requirements and 2bn Euros to compensate the retail bondholders).

Therefore, I strongly believe that we will hear other similar stories in the year to come, as Italy is not the only country facing non-performing loans (NPLs) issues that affect the banking sector. Therefore, political uncertainty in Europe will weigh on the single currency and increase investors’ interest to the US Dollar.

Chart 4. Italian 10-year yield versus EURUSD (inv.) (Source: Bloomberg)

ItalyandEuro.JPG

   3. The weakness in the Japanese Yen

In Japan, the BoJ introduced the ‘Yield Control’ operation in order to stabilize the steepness of the JGB yield curve, offering to buy an unlimited amount of debt at fixed yields to prevent a significant surge in rates. This is kind of a puzzle, as Japan Officials cannot afford higher yields [as many indebted developed nations], however too-low yields impact revenues of the banking system and the pension / mutual funds.

I don’t think the particular surge in USDJPY was explained by this new ‘BoJ Operation’ and I prefer to say that the Yen depreciation was a result of a Risk-on effect post-US election result in addition to the recent spike in US yields. USDJPY (Chart 5, candlesticks) trades above 117 and equities (Chart 5, red line) are above the 19,000 level for the first time since September 2015; and you can see how the increase in US yields (Chart 5, blue line) is ‘responsible’ to the Yen weakness.

The question now is to know if the late Q4 Yen weakness will persist in early 2017, with USDJPY pair attracting more and more momentum investors looking to hit the 125 resistance. We know historically that the [positive] trend on the USDJPY can halt [and reverse] very quickly if investors are suddenly skeptical about the global macro situation (Fed delaying its 2017 hike path, China liquidity issues or rising yields in peripheral European countries). On the top of that, if market starts to price in inflation in 2017, will the BoJ be able to counter a JGB tantrum and keep the 10-year JGB yield at around 0%?

One important thing about this recent Yen weakness though is that it allows the Japanese government to buy time in order to implement new reforms and increase productivity. If you remember well, Abe stated in September 2015 his 20% increase in Japan GDP in the medium term (increase from 500tr to 600tr Yen in 5 years).

Chart 5. USDJPY, Nikkei 225 and US 10-year yield (Source: Bloomberg)

OverallJapan.JPG

   4. The Chinese Yuan devaluation

Another currency that has been making the headlines is the Chinese Yuan. Over the past year, the Chinese Yuan has shed roughly 7 percent of its value against the greenback (Chart 6, USDCNY in candlesticks). At the same FX reserves (Chart 6, blue line) have been shrinking; reserves plunged by $69.1bn to $3.05tr in November (most in 10 months), bringing the reduction in the stockpile to almost USD 1tr from a record $4 trillion reach in June 2014. As Horseman Capital noted in their article on China (Is China running out of money?), if FX reserves continue to plummet and the PBoC wants to maintain control of the exchange rate, Chinese officials will face some difficult choices. One option would be to raise interest rates (the benchmark one-year lending rate stands currently at 4.35%) in order to reduce outflows and attract interest in the Yuan (high interest rate differential vs. the other countries). This would have a negative effect on the country’s growth outlook, which is already concerning the developed economies due to the high levels of corporate debt and overheated property markets. Another option would be to reduce the holding of deposits by cutting the reserve requirement rate (RRR) which stands currently at 17%. We can see in Chart 7 that the Asset-Liabilities spread (represented by Foreign Currency Assets and Deposits from Other banks) has narrowed drastically over the past year, therefore cutting the reserve rates for banks could be a temporary solution for the PBoC. The problem of the second option is that it will continue to weaken the Chinese Yuan vis-à-vis the US Dollar, which could increase political tensions between US and China.

Interestingly, an asset that has [sort-of] tracked the USDCNY move this year is the Bitcoin (Chart 6, red line) , which raised from $400 in January last year to over $1,000 today. The cryptocurrency was described as the ‘good’ instrument to circumvent capital control in China in periods of large capital outflows like today. Like gold, Bitcoin is readily available in China and can be sold for foreign currencies without problems and therefore have attracted a lot of buyers over the past year.

Chart 6. USDCNY, Bitcoin and Chinese FX reserves (Source: Bloomberg)

ChinaOver.JPG

Chart 7. PBoC Balance Sheet (Source: Horseman Capital)

PBoCBaS.JPG

To conclude, there are several factors explaining the US Dollar strength in the last quarter of 2016, and it looks like the trend should continue in early 2017 (extreme monetary policy divergence to persist in 2017, black swan events coming from Europe, difficulties of Chinese officials to deal with the capital outflows…). However its trend cannot persist indefinitely as we know that it will eventually have negative effect on the US economy in the long term. For instance, we know that a strong dollar hurts US companies’ earnings, which is already a problem if we look at the 12-month forward earnings (Chart 8, green line). In addition, if long-term interest rates increase persistently in the future (breaking through the 3-percent level seen in the 2013 taper tantrum), the US could face a budget crisis: how is the government going to fund its budget deficit [which is expected to grow over USD 1 trillion again under Trump presidency] if China and other central banks are liquidating US Paper at record pace?

Chart 8. SP500 overlaid with 12-month forward earnings (Source: Bloomberg)

ForwardEarnings.JPG

Dollar pause: poor US fundamentals or overall disappointment on more global easing?

Since its high in mid-March last year, the US dollar has ‘stabilized’ vs. overall currencies; if we look at the US Dollar index (Source: Bloomberg, DXY index), it hit a high of 100.40 in March 13th then has been ranging between 92.50 and 100 over the past year. Now the question I have been asking myself is‘what is the main reason for this stagnation?’

USDIndex

(Source: Bloomberg) 

I strongly believe that one of the main reasons comes from looser-than-expected FOMC statements and a shift in expectations on more monetary policy tightening in the near future. If we look at the market, Fed Funds futures predict a much lower ST rates in the future compare to the Fed’s dot plot. Looking at the chart below, whereas the Fed officials see rates at around 1% and 2% by the end of 2016 and 2017 respectively, the market (Red line) predicts 50bps and 1%. It doesn’t necessarily mean that the market participants are right, but it looks to me that they are more ‘rational’ based on current market conditions and this spread between the Fed and the market may have created a dollar pause over the past year.

FedPlotvsMarket

(Source: Bloomberg)

The first reason that could explain why the Fed has been holding rates steady since last December would be the poor fundamentals we have seen lately (except for the unemployment rate currently at 4.9%). For instance, US GDP growth rate has been slowing over the past three quarters and came in at 1.4% for the last quarter of 2015 (vs. almost 4% in Q2). If we look at the latest core PCE deflator release (the inflation figure the Fed tracks), the index came in at 1.56% YoY in March, still far below the Fed’s ‘target’ of 2%. In addition, the economic data have been more than disappointing overall, which could explain the recent fly-to-quality and why yields are starting to plunge again (the 10Y YS yield trades currently at 1.8%, while the 30Y is at 2.66%).

Secondly, corporate profits have been plunging and printed a 7.8% fall in Q4 2015, the biggest decline since Q1 2011 (-9.2%) and the fourth decline in the last five quarters. If we look at chart below, we can see that the divergence between the S&P500 index and the 12-month forward earnings doesn’t work for too long and equities tend to be the one moving in general. You can see that in that case, equities are still overvalued based on this analysis and there is more potential downside coming in the future.

SPXFEPS

(Source: ZeroHedge)

The third and most important reason explaining this status quo – i.e. US dollar pause – would be the current global macro situation. Certainly, market participants have been recently disappointed by the recent news coming either from Japan (no additional QE see article) or the Eurozone and the loss of confidence in the ECB. On March 10th, Draghi announced the ECB Bazooka plan, where the officials decided to:

  • cut decrease the deposit refi and marginal lending rates to -0.4%, 0% and 0.25% respectively
  • Increase the QE from 60bn to 80bn Euros per month
  • Implement a four new target LTROs (TLTROs) each with maturity 4years
  • Include investment grade euro-denominated bonds issued by non-bank corporations clong the assets that are eligible for regular purchases

The effect on the market was minor; if we look at the chart below, the Euro increased in value against the greenback (green line) and the equity market stands at the same level since the announcement (Eurostoxx 50 index trading slightly below 3,000).

EUROstoxx

(Source: Bloomberg)

The sales-side research suggest that CBs should consider purchasing equities as well or taxing wealth (Deutsche Bank) as a intermediate step before implementing the Helicopter money strategy.

Despite a recent spike since the beginning of the year mainly driven by the recovery in oil prices (WTI spot increased from 26$ to 43$ per barrel), commodity prices are still trading at their lowest level since 1998 according to the Bloomberg BCOM index (see chart below). China’s (and other EM countries’) slowdown continue to weight on international finance putting a lot of export-driven countries into difficulty (or close to default). I personally believe that this situation will remain in the next 12 to 18 months as the emergence of a credit crisis in the EM market is not too far away.

CommodityPrices

(Source: Bloomberg)

Therefore, I think the global lack of easing will tend to stabilized the US dollar in the medium term; another rate hike from Yellen in one of the next two meetings is sort of priced in by the market, therefore only action from the rest of the world could start to bring interest into the US dollar. I would be careful of going short equities at the moment as USDJPY is very low and a response from the BoJ (more ETFs purchases) is kind of imminent if Kuroda wants to stop this current equity sell off and Yen purchases.

 

 

Quick update on China ahead of the FOMC meeting…

Ahead of the FOMC meeting this week, I thought a quick update on China would be useful to review the major data on a global macro perspective.

Over the past few years, Chinese slowdown has massively impacted commodity prices, which are still ‘trying’ to find a bottom according to the late analysis I read. The chart below shows the historical moves of the Bloomberg Commodity Index (BCOM), a broadly diversified commodity price index (22 commodity futures in seven different sectors) that I like to watch quite a bit. As you can see it, the index has been trading below the 2009 lows since the beginning of the year and is now approaching the 2002 levels.

Commodity

(Source: Financial Times)

If we look at Iron Ore monthly prices for instance (see chart below), we can see that the commodity has lost more than three times its value since its high in February 2011. It fell from 187.18 (US Dollars per Dry Metric Ton) at that time to 56.40 (for the September 2015 Futures contract). There has been a few topics on the table that could have describe this drop – US rising rates and Dollar strength, Grexit fear, Oversupply issues – however the decrease in Chinese growth and productivity are the most important factors to the commodity market in general.

Iron Ore

(Source: indexmundi website)

How fast is China slowing?

First of all, if we look at the country’s annual growth rate over the past five years, China GDP decreased from approximately 12% in early 2010 to 7% in the last Q2 update. And looking at the major’s institution forecasts (IMF, World Bank, see below), it is more than likely that we are going to see lower and lower figures in the next few years, and therefore constantly weigh on export-driven economies. Based on the forecasts below, we are looking at a 5.5%-6% annual growth rate in 3 to 5 years.

ChinaGDP

(Source: knoema website)

Salaries increase in China, a secular change?

For decades, China has mostly been competitive based on its cheap labour and low-cost raw materials, and has been profitable based on its export-driven economy combined with an ‘undervalued’ exchange rate. However, with wages and transportation costs on the rise, the country’s economic projection has changed and I don’t know if the rest of the World is yet prepared for it. According to some financial analyst experts, compare to the mid-2000 levels, China needs twice the amount of Capital or Debt to create a 1-percent growth today.

Based on the International Labour Organization’s 2014 Wage report for the Asia Pacific published at the end of the first quarter of this year, Asia annual growth in real wages has been outperforming the global average over the past decade (6.0% vs. 2.0% in 2013). And East Asia (driven by China) reported at 7.1% increase in 2013, therefore indicating a growing consumer spending power. And between 1998 and 2010, the average annual growth rate of real wages were approximately 13.8% (Carsten A Holtz, 2014). Since 2010, real wages have grown by 9%, outperforming productivity which has grown by 6-7%, therefore reflecting negative signs about the economy.

Availability of a large pool of labour combined with low production costs have been one of the major pros of China, however the constant increase in labour costs will narrow the difference in manufacturing costs between China and a developed economy (such as the US) to a degree that is almost negligible.

As a result, no hike in September…

My view goes for a neutral FOMC statement this week, but no hikes from the Fed based on the weak current market’s conditions. If we look at it, we have more and more EM countries facing a currency crisis (Brazil, Russia, Malaysia…), low oil prices affecting highly leveraged US Shale oil companies, US debt ceiling ‘threat’ at the end of the month, China selling its USD FX reserves, US equities showing a sign of fatigue… These are all negative elements that the US policymakers will take into account at the September meeting (16th / 17th of September). The upside for currencies such as the Euro, the Swiss or the Sterling pound will be quite limited until the release of the FOMC Statement, however we could see some Dollar weakness in case of a status quo.

The ‘Obama’ Dollar Rises…

Over the past few weeks, I had several discussions with some friends of mine to try to understand and clarify the US Dollar ‘pause’ we have seen since the middle of March. A dovish stance from the Federal Reserve, which obviously led to a status quo at the June FOMC meeting, may have halted the Dollar bulls, but it seems to me that the market is getting more and more confident about this year’s lift-off.

Based on the forecasts made in June, the Fed Staff expect policymakers to raise the Fed funds rate to 35bps by the end of the fourth quarter of 2015, which implies a one quarter-point hike this year (chances of an initial move at the September meeting stand roughly at 60%).

Quick recap’ on the macro figures

Even though the unemployment rate hit a 7-year low at 5.3% in June (with a strong NFP at 223K) and Q2 GDP came in at 2.3% (above the 2% ‘target’, but still below Wall Street’s consensus estimate of 2.5%), the rest of the figures and the overall macro/geopolitical situation both don’t look quite good. US inflation has average 0% since the beginning of the year (0.1% YoY in June), consumer spending YoY declined for the third consecutive month and both business fixed investments and net exports stayed soft. On a broader scale, the commodity-meltdown continues as demand from China may slow even further on the back of a weak manufacturing activity (Chinese PMI fell to 47.8 in July, its two-year low). For instance, NYMEX WTI September futures are trading near levels not seen since March, with September contract at $46.30 per barrel.

In addition, even though the Economic and Financial Affairs Council (ECOFIN) approved a 7.1bn-euro bridge loan to Greece last month (July 17th) given through the EFSM so that the country could meet its short-term obligations including a 3.5bn-euro payment to the ECB on July 20, Athens has no money left. That is problematic as a second big 3.2bn-euro payment is coming on August 20 to the ECB and there are talks that they may miss it as the bailout timeline is ‘unrealistic’.

Chinese economic slowdown, low oil prices, deflation and Greek payments are all subjects that I try to follow closely as it is the topics I believe that US policymakers are watching as well. However, I think this time the Fed officials are quite ready for a lift-off in September, and now I have been questioning myself about the US Dollar rally.

The Dollar Rallies…

The chart below shows the three dollar rallies that occurred since the collapse of the Bretton Woods system. The first big one is the Reagan dollar rally in the early 80s, fueled by the tight monetary policy. As a result of the second oil shock in 1979, chairman Volker orchestrated a series of interest rate increases that took the federal funds target from 10 to nearly 20 percent. If the Euro had existed then, the single currency would have depreciated by roughly 60%. The rally was eventually halted in September 1985 by the Plaza Accord signed by five governments to depreciate the US Dollar in relation to the Japanese Yen and the Deutsche Mark.

The Clinton Dollar rally started in the mid 90s fueled by the US Tech bubble and capital inflows into the US equity market in addition to the US government running federal surpluses. This surge brought the Euro down to 0.8230 against the greenback and USDJPY was trading at a high of JPY135 at the end of the rally (late 2001).

The recent Obama rally has started in early July last year as a result of monetary policy diverge between the US and the rest of the World. The commodity meltdown will continue to weigh on commodity currencies and especially on the Dollar-Bloc (CAD, AUD and NZD), as Greece will continue to make the headlines until Bailout#3 is eventually agreed.

As you can see on the chart below, I added a downtrend line that was broken in the beginning of the year. The US Dollar index hit a high of 100.80 in mid-March before its March-May consolidation. It looks to me that the greenback is gradually recovering from its quick contraction.

DXY avec MA

Source: Reuters

Despite a low volatile market at the moment, I am convinced that the US Dollar will gain strength in the end of this second semester. I will try to add a currency-detailed article by the end of the week with my new levels on the main currency pairs.

Post FOMC Analysis, Dollar Flash Crashes…

This week has been full of macro events (four central banks meetings – BoJ, Norges Bank, SNB and the Fed), however all eyes were on the FOMC statement that came up yesterday. Dovish stance from Yellen in addition to 2015 forecasts revised on the downside created Dollar ‘Flash Crashes’, with the FX market completely out of control. The US Dollar index was trading around 100 yesterday morning, then went down from 99.50 to 98.00 after the FOMC, and eventually ‘flash-crashed’ after the US close. EURUSD (and Cable) soared by 400 pips (and 500 pips) to 1.1040 (and 1.5160 respectively), USDCHF down 4 figures as well down to 0.9620. The yen was less reactive (which clearly shows the declining Yen Pavlovian response the risk-off environment, USDJPY went down ‘only’ 200 pips to 119.30.

To review the FOMC statement briefly, the Committee revised down all 2015 forecasts since the previous Summary of Economic Projections (SEP) released on December 17 last year. The median dot plot for year end 2015 decreased from 1.125% to 0.625% (down by 50 pips). In addition, looking at the Fed’s dot plot for the year 2016 and 2017, we can see that the median dot for 2016 fell to 1.875% in March (vs. 2.5%) and decline to 3.125% from 3.625% for 2017.

FOMC DOT plot

 (Source: Fed’s website)

Furthermore, if we look at the table below which shows the advance release of the SEP, we can see that the central tendency for GDP this year was decreased to 2.3%-2.7% (from 2.3% – 2.7%), PCE inflation (the inflation measure watched by the Fed as the PCE index covers a wide range of household spending) went down to 0.6% – 0.8%, compared to 1.0% – 1.6% three months ago.

FED Forecasts

(Source: Federal Reserve’s website)

While the Dollar has been recovering all day (especially during Asia, USD index now trades back at 99.40, with EURUSD back down to 1.0660, USDCHF up to 0.9910, Cable down to 1.4740 and USDJPY at 120.80), the market is still a bit ‘stress’ with all core bond yields trading to lower levels (See appendix, Bund at 19bps, US 10Y at 1.95% or UK Gilt at 1.52%) and peripheral EZ bonds trading higher than yesterday’s levels.

As a result, the equity market (S&P500) is back on track after a quick 70-point bear consolidation as I was looking for (see tweet @LFXYvan on Feb 26). If we look at the chart below, we can see that the 100 SMA has acted as a sort of support where the market found some potential buyers-on-dips. Over the past few months, it looks like if the 100 SMA didn’t hold, the 200 SMA was doing the rest of the job (except in mid-October).

SP500

(Source: FXCM)

Even though the equity has lost a bit of ‘power’ since the Fed stepped out of the bond market at the end of October last year (the bear consolidation are becoming more and more recurrent), I still believe there is some potential room on the upside based on yesterday’s comments and readjustments.

I am curious to know how the US policymakers will play the rate hike within the next few months (will there be one in June?), as even if the job market has continued to show some strong figures with a NFP report at 295K in February and an unemployment rate at 5.5% (close to full employment according to economists), there has been a lots a disappointing macro figures. See list below with all the misses in just the past month…

Misses US

 (Source: ZeroHedge)

Earlier today, the SNB left its deposit rate negative at -0.75% and jawboned a bit about the recent CHF appreciation. EURCHF is trading at 1.0550, down 2.5 figures in the past month and potentially ‘hurting’ the Swiss economy (Swiss is also part of the ‘Currency War’ party). Norway unexpectedly left its interest rates unchanged and signalled in its report that another cut was planned to protect the Norwegian economy from the plunge in oil prices. The NOK rocketed against the greenback earlier today, down from 8.37 to 8.07 on this hawkish surprise. As a reminder, Oil (and gas) generate more than 20% of Norway’s output, and the country may be in difficulty if this low-oil-price era persists. Norway may have to ‘tap’ into their sovereign wealth funds – Government Pension Fund Global – (approx. $850bn) in order to support their annual budgets this year. However, the maximum that the government could spend from oil revenue is 4% of the fund (by law).

Otherwise, no surprise from Japan and the BoJ stood firm on Tuesday, leaving its monetary policy unchanged (80tr Yen of asset purchases annually, mostly JGBs), even though policymakers acknowledged that prices might start falling in the coming months. Consumer prices in Japan rose 2.4% YoY in January, the same as the previous two months and down from 3.7% in April last year.

 Appendix: Bonds yields…

BBG

 (Source: Bloomberg)

Don’t fall in love with your US Dollar positions…

As you know, the Fed stepped back from the market by announcing the end of the QE3 era last Wednesday. However, another major central bank, the BoJ, took over by increasing [eventually] the amount of its current bond-buying program by 10tr Yen to 80tr Yen (and tripled its purchases of ETFs to 3tr Yen). You saw the consequences since then, with USDJPY that tested a new 7-year high at 114.00, up almost 5 figures in two business days. The Nikkei closed above the 16,400 level on Friday (16,413.76), but didn’t participate to the overnight development as Japanese market were closed due to Culture ‘holiday’ Day.

To sum up, the Fed is done with QE [for the moment], however we have two other big players – ECB and BoJ – which are trying to do whatever it takes to keep pushing asset prices higher. As a reminder, the ECB plans to increase its total balance sheet by 1tr+ EUR within the next couple of years to come (now is it possible? That’s a different story. See article ECB dilemma: Whatever it can…).

It looks to me that the chart to watch now is the total big-4-central-bank balance sheet. As you can see it on the chart below, 10.5tr USD were injected into the market since the GFC; and from what I hear and read, we are far from done…

CBs

(Source: Barclays)

One thing that makes me uncomfortable at the moment is the sharp appreciation of the US Dollar against all the currencies. I believe even though US policymakers are conscious the USD will strengthen in the long term, however I think that they are looking for a slow and gradual increase.

In its last minutes, the Fed expressed its concerns about the rising dollar (too fast indeed is what they meant) and its negative effect on inflation and US exporters. The market has to accept that, otherwise the topic will come back on the table each time (minutes, meeting, semi-annual testimony…).

Quick update on the Euro

The single currency broke its strong support at 1.2500 against the greenback (which represents the 76.4% retracement of the 1.2040 – 1.3991 interval) and the pair is now trading at a 2-year [and 2-month] low, down 11% over the past six months. There are rumours (ECB Source) that the Fed launched currency war telling the ECB not to push it too fat (concerning its exchange rate). It tells you that the next and final retracement traders will look at is the 1.2040 low reached on July 20 2012.

EUr03Nov

(Source: Reuters)

FX positioning

I am still comfortable on being short EURGBP, targeting the 0.7750 retracement (entry level 0.8000, stop loss decreased to 0.8000). Watch the ECB and BoE meetings this Thursday.

I would like to add another position on today’s update: short AUDNZD at current levels (1.1270), with a target at 1.1140 at first and a stop loss above 1.1360. I know that the late inflation figures in NZ (which came in lower than expected at 1% YoY vs 1.3% consensus) will weigh on RBNZ officials to consider getting back in the tightening cycle, but I am comfortable with short the pair at the high of the range as you can see it on the chart.

AUDNZD03Nov(Source: Reuters)