Lessons from the Pros

Sound as a Pound

I’m writing to you from London this week, where the currency market is a prime topic of discussion. Forex is on the front page as the Great Britain Pound has finally done it, reaching the long-awaited landmark of 2.0000 vs. the U.S. Dollar. In simple terms, this means that one British Pound is now worth two U.S. Dollars. The Pound is now at its strongest level vs. the buck since 1992 (see figure 1).

1990-2007

Figure 1: Great Britain Pound reaches a 15-year high vs. U.S. Dollar. Source: Saxo Bank

Forex is a major part of the trading culture here, because London is home to some of the world’s biggest and best currency traders. The U.K/ European trading session generates more Forex trading volume than any other, and London is recognized as the world’s capital of currency trading, with New York considered a distant second and Tokyo third.

What was the catalyst for the final thrust higher? Last week, a report on U.K. inflation launched the Pound into the stratosphere when it showed that consumer prices rose at an annual rate of 3.1% (see figure 2). The governor of the Bank of England, Mervyn King, was forced to write an historic letter to the chancellor, Gordon Brown, explaining why inflation climbed more than one percentage point above the 2% target, and what he proposes to do about it. It marked the first time in 10 years that such a letter needed to be written. Higher interest rates now appear inevitable, and mortgage lenders have responded by pulling their fixed rate deals in anticipation of a May rate increase.

Figure 2: GBP rallies vs. USD on a strong inflation report. Source: Saxo Bank

The fanfare surrounding the event was reminiscent of Dow 10,000 in the U.S. Giddy Londoners are talking about visiting New York, or buying property in Florida. Housing is cheap in the U.S. compared to London, despite the steep climb in U.S. housing prices. Meanwhile, the U.K. – along with Europe – is becoming more expensive for U.S. citizens. Expect tourism from the U.S. to the U.K, and Europe to fall, and a surge of vacationers from across the Atlantic enjoying their holidays in the U.S.

The weak greenback could also help U.S. companies by making exports cheaper to overseas buyers. Meanwhile, strength in the Pound and the Euro (which is within shouting distance of its highest point vs. the U.S. Dollar since the inception of its use) could make the exports of those countries less attractive by comparison.

Will the damage to the buck continue? The U.S. Dollar Index, after breaking major support last week, continued to head south (see figure 3).

Figure 3: US Dollar Index (USDX) continues its descent. Source: FX Street

In last week’s article, "The Clubber Lang Index", we noted the USD Index’s ominous break beneath the December lows. Well, we can see that in the past week, the index’s losses have accelerated. In all fairness, the negativity surrounding the greenback has been so pronounced recently, that I wouldn’t be surprised to see a bounce in the USDX. If this happens, look for resistance at the former support area near 82.50. A look at the weekly chart of the index does nothing to assuage fears that the dollar has further to fall, as it reveals a series of cascading lower highs and lower lows (see figure 4).

Figure 4: Weekly chart of US Dollar Index (USDX) reveals a long-term downtrend. Source: FX Street

The next major psychological hurdle for the buck involves the Euro/ U.S. Dollar (symbol EUR/USD). In late 2004, the pair reached its high near 1.3665. At the time of this writing, it rests less than 70 pips away from that major high (see figure 5).

Figure 5: Euro is challenging its 2004 highs vs. the U.S. Dollar. Source: Saxo Bank

What are the potential catalysts for a break higher? Euro has been held back by political uncertainty, as elections to determine the next president of France have taken center stage. Currency markets generally react unfavorably to political uncertainty, but after this weekend’s first round of elections, the picture has become considerably clearer. Now the two remaining candidates, Nicolas Sarkozy and Segolene Royal, will enter into a runoff election on May 6 to determine the ultimate winner.

The French economy is the second largest of the countries that use the Euro as their primary currency. Of that group, only the German economy is larger. Certain economic indicators can create volatility in the Euro. Once such indicator, the German IFO Business Survey, is scheduled for release early on Wednesday, April 25. This is another potential catalyst that could send Euro to new highs vs. the U.S. Dollar.

Forex Mailbag

As always, thank you for your questions and comments – please keep them coming! Here is our question for the week:

Q) Dear Ed: Since interest rate in Australia is higher than that in the US, does it mean that if I buy the AUD/USD pair I’m engaging in ‘carry trade’?

Ed Ponsi) Great question. Traders collect interest when they are long the higher yielding currency and short the lower yielding currency. Since the current rate of interest set by the Reserve Bank of Australia (RBA) is 6.25%, and the Federal Reserve has set U.S. rates at 5.25%, traders can collect interest by going long the AUD/USD (Australian Dollar/ U.S. Dollar) currency pair. However, since the difference in the two interest rates is relatively small (6.25% minus 5.25% = 1.00%), the payoff to a trader who is long this pair would also be small.

When traders refer to the ‘carry trade’, they are generally referring to trades that allow them to collect a more substantial amount of interest. For example, the AUD/JPY (Australian Dollar/ Japanese Yen) currency pair offers a more attractive alternative for Forex traders who are seeking yield. The Bank of Japan has set rates at 0.5%, so the differential in the AUD/JPY pair is 5.75% (6.25% minus 0.5% = 5.75%). Carry traders will find this much more compelling than the current AUD/USD yield of just 1.00%.

Will the rate differential between Aussie and U.S. rates widen? Australia’s strong economy – buoyed by strength in commodities prices – will almost certainly force the RBA to raise rates to 6.5%, possibly as early as next month. Meanwhile, interest rate futures currently predict that U.S. rates will fall to 5.00% by the end of this year. The result will be a wider interest rate differential between Australia and the U.S. If the differential widens substantially, carry traders may eventually find the pair attractive.

Have a question about Forex trading? Send an email to eponsi@tradingacademy.com and we may use your question in an upcoming newsletter. Until next time, best of luck to you in trading.