Britain Shocks the World

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January 16, 2007

By Ed Ponsi, Online Trading Academy, Equities, E-mini Futures, Options, Technical Analysis Strategies, Platform Immersion, and Personal Trading Plan Instructor

We saw some volatile moves in the currency market this week, and the most notable of these was Thursday’s spectacular rally in the Great Britain Pound. Sterling gained an incredible 375 pips in one day against the hapless Japanese Yen, which sagged across the board following last week’s rally. The average daily range of the Great Britain Pound/Japanese Yen (GBP/JPY) currency pair, as measured by the Average True Range indicator, is just 175 pips, so Thursday’s volatile move was more than double the average daily range for the pair. The rally continued into Friday, pushing GBP/JPY to a new eight-year high. In all, The Pound has crushed the Yen for a total of 590 pips in just five sessions, from January 8th through January 12. Note that last week’s rally was initiated after a 50% Fibonacci pullback
(see Figure 1).

Figure 1: British Pound erupts vs. Japanese Yen after a 50% Fibonacci pullback.

The Pound also hammered the Euro, reaching a nineteen-month high against the single currency, and recovered much of last week’s losses vs. the U.S. Dollar, which has been surprisingly resilient in early 2007. The fireworks were ignited by the Bank of England (BoE), which surprised nearly everyone by raising interest rates by 25 basis points. It was the second time in five months that the BoE’s Monetary Policy Committee (MPC) fooled analysts with an unexpected rate hike, subsequently roiling the currency markets and creating a wave of GBP panic buying.

The move puts the U.K. benchmark interest rate at parity with its U.S. counterpart, with both at 5.25%. Both are well above the European interest rates, currently at 3.5% and expected to rise to about 4% this year. U.K. rates are expected to rise to at least 5.5%, and possibly as high as 5.75% later this year.

Why raise rates now? In Britain, inflation has been running above the central bank’s 2% target for seven successive months and is now at 2.7%. Some analysts suggest that upcoming economic figures will show inflation running at a 3% rate, so the MPC was forced to act in order to keep prices in check.

The Magic Word

The issue here is not higher U.K. interest rates, but the jarring way in which this rate hike was implemented. Only one of the 50 economists polled by Reuters predicted an increase in rates at the January meeting, which shows that the MPC did a poor job of telegraphing its most recent decision. Compare this to the U.S. and European central banks, which go to great lengths to keep markets informed of their intentions through the use of code words and phrases.

In recent years, the phrase “pace that is likely to be measured” was added to Fed statements to indicate that a U.S. rate hike was imminent; when this language was removed from FOMC guidance, it was understood the campaign of rate increases was drawing to a close. This is a masterful example of the Fed using a seemingly innocuous phrase to control market expectations.

Taking a page from the Fed’s playbook, the European Central Bank’s President, Jean-Claude Trichet, has adopted the word “vigilant” as a code word to indicate that a rate hike is on the way. In fact, just 90 minutes after the MPC goosed the markets, the Euro cracked badly due to Trichet’s reluctance to use the “V-word” during a speech, which came on the heels of the central bank’s decision to keep rates steady at 3.5%. It’s important to note that the Euro’s decline did not come as a result of the interest rate decision, as maintenance of the 3.5% rate was widely anticipated by analysts
(see Figure 2).

At the press briefing following the rate decision, Trichet replaced the word ‘vigilant’ with ‘very closely monitoring’ when talking about European Central Bank policy. Currency players interpreted that change in a dovish manner as Trichet’s use of the ‘vigilant’ term has preceded recent hikes. This change of language essentially rules out a February rate hike, with traders now setting their sights on March.

This shows exactly why the Forex market is a news trader’s dream. The trader who understands these semantics and how they are used knows that if a Trichet comment that the European Central Bank remains ‘strongly vigilant toward inflation’ were to unexpectedly cross the newswire, the likely result would be a sharp, tradable rally in the Euro.

Will the Bank of England follow suit and create its own buzzword? Some traders enjoy these massive spikes in volatility while others curse them, but one thing is certain – the situation is avoidable. It seems that for now, the Bank of England places less importance on orderly markets than its counterparts in the U.S. and Europe. Nimble traders who can interpret news quickly will continue to use this information to their advantage.

Loonie Traders Load the Boat

The U.S. Dollar had a rough finish to 2006, but still managed to roll over the beleaguered Canadian Dollar (popularly known as the ‘Loonie’) with considerable authority in the fourth quarter. From September 1st through January 11th, the U.S. currency gained more than 750 pips vs. its northern neighbor, topping out near 1.1800. The pair has no significant support in sight prior to the 1.1505 Fibonacci retracement
(see Figure 3).

Figure 3: U.S. Dollar pummels Canadian Dollar in Q4 of 2006; resistance at 1.1800

However, signs are pointing to a possible resurgence in the Canadian Dollar. According to the Commodity Futures Trading Commission, as of January 9 futures traders were net short the Loonie to the tune of 84,906 net contracts, up from up from 74,268 the prior week. The fact that shorts have ‘loaded the boat’ could be viewed as a positive for the Canadian currency, since any strength in the Loonie could result in a massive short covering rally. When we cover a short position, we are essentially buying back that position in order to go flat. Any short covering rally in the Canadian Dollar at this time has the potential to create a gigantic move.

Combine this with the fact that a) the pair has met significant resistance at 1.1800, where it has stalled for the past week, and b) despite the reversal in Q4, the U.S. Dollar remains in a significant long-term downtrend vs. the Canadian Dollar (see Figure 4), and we could be witnessing the development of a ‘perfect storm’ in the USD/CAD currency pair.

Figure 4: U.S. Dollar in a multi-year downtrend vs. Canadian Dollar

The Canadian currency still faces formidable challenges, most notably the recent declines in energy prices (Canada is a net exporter of oil) and other commodities, such as copper and lumber. Since commodities account for more than 50% of Canada’s exports, the recent price declines reduce the amount of capital flowing into Canada for the purchase of these goods. Because capital inflows are a major source of strength for a currency, this reduced inflow of capital places pressure on the Canadian Dollar. Due to the existence of these cross-market relationships, traders who monitor commodities prices closely have a clear edge when trading the Canadian currency.

Until next time, best of luck in trading!

Disclaimer
This newsletter is written for educational purposes only. By no means do any of its contents recommend, advocate or urge the buying, selling or holding of any financial instrument whatsoever. Trading and Investing involves high levels of risk. The author expresses personal opinions and will not assume any responsibility whatsoever for the actions of the reader. The author may or may not have positions in Financial Instruments discussed in this newsletter. Future results can be dramatically different from the opinions expressed herein. Past performance does not guarantee future results. Reprints allowed for private reading only, for all else, please obtain permission.

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