Sterling suffered another minor onslaught last week to finish August as the weakest performing G10 member, as the euro and dollar eroded its value with a combination of negative domestic news and better than expected news from outside the UK. A midweek reading showing that business investment had shrunk dramatically for the quarter stoked fears that initiatives to stimulate the UK economy were failing to filter through to the wider economy and helped spur the pounds decline over the week. The week ending GDP result saved the pound from a complete meltdown, revealing a marginal improvement on the consensus of a 0.8% contraction for Q2.
Highlighting the trend for upside surprises outside of the UK economy was Germany’s bullish growth data on Monday, and a midweek IFO business climate reading showing an improvement in German confidence for the fifth month running. Euro zone inflation figures early yesterday also suggest that the brush with the deflation devil may be a short-lived phenomenon for the 16 country region. Figures revealed that prices still managed to undershot the target rate of 2% by some way, however the (-0.2%) figure was a clear rebound from the year on year figure of a (-0.7%) shown in July.
Thursday sees another European Central Bank (ECB) interest rate decision, with consensus overwhelmingly for a hold on rates. While things are beginning to look rosier in the euro zone, there is still plenty to worry about for the Central Bank. Last week’s capacity utilisation survey highlighted how much further the euro zone has to get back to optimum levels of output. Weak underlying inflation figures also leave plenty of reason for the ECB to not hike rates anytime soon, and we don’t forecast any tightening of monetary policy to begin until early 2010. The impact of the meeting will therefore be decided by the tone that the Trichet uses in the post match conference, rather than any headline decisions.
The importance that interest rates play in the dictating the direction of the domestic currencies is illustrated below. It shows the recent correlation between the GBP/EUR exchange rate and the interest rate differential between the UK and euro zone since early 2007. The pound was performing better in a climate with higher interest rates and appetite for yield and risk. Once the yield difference dipped into the negative territory as the credit crisis struck (because UK rates moved to lower than ECB rates), the pound has struggled to cope. This is not only indicative of the yield difference itself, but rather that the sudden lowering of UK interest rates was as a result of a dramatic domestic contraction. The first economy to hike interest rates will therefore likely strengthen their respective currency, as it will signal an ending of their recessionary cycle.
The dollar will be moved around this by the all important non farms reading on Friday, as well as FOMC minutes from the last rate meeting on Wednesday. Sterling has early month PMI construction and services readings to deal with also, later in the week.
Trade idea of the week
This week’s trade idea of the week is a Risk Reversal for a seller of GBP and buyer of USD.
This Premium Paid Risk Reversal gave the client a worst case rate of 1.61 and a best case rate of 1.76 for an upfront premium of 1.7% - 2.0% depending on the total size of the contract.
If, on expiry, GBP/USD is below 1.61 the client will receive 1.61, if it is between 1.61 and 1.76 the client will buy at spot, and if it is above 1.76 the client has an obligation to buy at this level.
