Lessons from the Pros

On Monday morning, February 19, I awoke to find a surprise gift. It was not located under a tree, but it appeared to me in the form of a sharp sell off in the Great Britain Pound.

As I rubbed the sleep from my eyes, turned on my computer and checked the charts, there it was – GBP/USD (Great Britain Pound/ U.S. Dollar currency pair) had fallen about 100 pips, with most of the plunge occurring in a swift thrust. Please note that the time of day on the charts is based on Greenwich Mean Time, or GMT, which is the international time used by most Forex traders (see figure 1).

Figure 1: GBP/USD falls hard in early trading on 2/19/07. Source: Saxo Bank The first thing I wanted to know is why this currency pair was falling from the sky. I browsed the news wires and found that the Bank of England (BoE), which determines monetary policy and interest rates for the United Kingdom, had made a series of startling comments that spooked traders into selling the British Pound. On one newswire I saw the following headlines marching across my screen:

10:17 GMT BOE: Some GBP Depreciation Needed To Close Curr Acct Deficit

10:19 GMT BOE: Effective Labor Force Unlikely To Grow As Rapidly Ahead

10:23 GMT BOE: Sharply Rising Asset Prices Raises Correction Threat

10:26 GMT BOE: Can’t Guarantee UK Econ Will Be As Stable Ahead

10:26 GMT BOE: Global Current Acct Imbalances Look Unsustainable

10:27 GMT BOE: Low Level Of Real Rates, Risk Premia Look Unsustainable

Source: Dow Jones Newswire

That first headline is a real eye-opener – The Bank of England is saying that the Great Britain Pound must fall, in order to clear up some deficit issues. Yikes!

From there, the news just got worse; the growth of the labor force will slow, asset bubbles may be forming, the economy is likely to become less stable – the Bank of England sounded as if Armageddon were approaching. No wonder the Pound got pounded!

Up to this point, every headline was just that – a headline. There was no story attached to any of these headlines, so we did not know the context in which those comments were made. The only things we knew for sure is that the comments sounded awful, that the Pound was getting crushed, and it was likely to continue.

Then, as legendary radio announcer Paul Harvey might say, we heard “The Rest of the Story”. A newswire headline that referred to the Bank of England appeared with a complete news story attached. The story cleared up a few issues; yes, the Bank of England’s decision-making body (called the Monetary Policy Committee, or MPC) did say that the British Pound would have to weaken at some point in the future.

Here’s the kicker – the title of the report that contained all of these negative comments was “MPC – 10 Years On”. Ten Years On, as in ten years into the future. So all of these negative comments did not refer to anything that might happen in the immediate future; instead, they referred to a series of bad things that might happen ten years from now. It would be logical to surmise that when traders digested this information, the GBP/USD pair would reverse direction. I immediately planned a trade based on the potential for the British Pound to recover and the GBP/USD pair to climb back to its levels prior to the release of the news announcements. Our entry order was executed as the pair began to recover, and a close stop was placed beneath the major low. It took a while but the pair eventually recovered all of the losses sustained during the sell off (see figure 2).

Decisions, Decisions

The Bank of Japan (BoJ) is slated to decide whether or not to raise interest rates this week. Last week’s strong Japan GDP numbers (the economy is growing at a rapid 4.8% annual rate) make an increase in Japan’s benchmark rate to 0.5% likely, as does last month’s controversy over the Bank of Japan’s failure to raise rates. At that time, Japanese government officials seemed to overtly steer the BoJ away from a rate hike, and in the process created the perception that Japan’s central bank is under the government’s thumb. BoJ and government officials then went into full-on spin mode, struggling to create the impression that the BoJ is in fact still in charge of the monetary decision making process. One way to indelibly imprint that impression on the minds of traders everywhere would be for the BoJ to raise rates this week. Japanese government officials clearly don’t want to see higher interest rates, and this would be a great opportunity for the BoJ to assert its independence.

To a degree, a rate hike is already priced in to the market. Will the Yen strengthen if the BoJ raises rates? That depends on the statements that come from Bank of Japan officials in conjunction with the decision. This is true in the case of most rate decisions; the rate move is often already anticipated, but the statement, which gives forward guidance, is more difficult to predict.

Until next time, best of luck to you in trading.