By DAVID JOHNSON
THE FOREIGN exchange markets have always kept a wary eye on the bond markets, because the immense flows created by international investors, in search of higher interest rate yields, cause intermittent increased demand for certain currencies and an oversupply of others. Understandably, currency traders are always keen to anticipate these flows, because there are profits to be made and losses to be avoided by doing so.
No wonder then that every word spoken by any central bankers is examined in minute detail, in a search for the titbit of information or nuance of phraseology that will give the trader an edge. And, while it is a tad unattractive to watch grown men and women biting their nails; fearful that the utterances of the head of the US Federal reserve might cost them money, that is exactly the picture we saw at 6.15pm GMT on May 10.
Only traders who had been abandoned on a desert island for a year would not have expected the Federal Reserve to raise the US base interest rate to 5.0 per cent, but traders and analysts were far less certain about what the head of the Fed, Mr Bernanke, would say at the press conference that followed the decision. Mr Bernanke had let slip that they would have to consider a pause to the interest rate hiking cycle that had brought the US base rate from 1.0 per cent to 5.0 per cent in 16 straight rate hikes, over a period of two years. That was hardly an unexpected development but as soon as the words had left his lips, the markets started to sell dollars, on the assumption that the relentless rise in US interest rates was at an end. This was enough to cause a 10 per cent drop in the value of the dollar in a matter of weeks.
As it turned out, Mr Bernanke’s comments were as mixed as they were non-committal, and that left traders with the option to either sell more US Dollars or buy back some of the Dollars they had already sold. A day of manoeuvring followed, concluding in a decline in the value of the US Dollar against both the Euro and the Pound, and these exchange rates rallied to levels not seen in more than a year. This left traders to decide whether they preferred to hold euros or sterling when they sold their USDs.
On balance, the pound appeared to be the weapon of choice, and that had a lot to do with the market expectations of the next interest rate moves from the Bank of England (BOE) and European Central Bank (ECB). The general perception after the BOE inflation report is that UK interest rates will stay at 4.5 per cent for the majority of the summer, and maybe even rise towards the latter part of Quarter three. The BOE stated that they see UK inflation rising and then returning to their target rate of 2.0 per cent over the next two years, and that they would only need to raise the UK base rate marginally in order to temper retail enthusiasm.
The European Central Bank, on the other hand, is far less clear cut in its thinking. Their rhetoric speaks of ‘strong vigilance’ on prices and inflation, but fails to forecast when or if EU interest rates will rise. Many in the markets feel that, with the resurgence of Germany’s economy and the slide in Eurozone unemployment, interest rate rises are inevitable, and that view has helped the Euro make immense headway against the US Dollar.
So the juxtaposition between the ECB and the BOE is such that traders are marginally more inclined to expect the BOE to raise rates further than the ECB, and the starting point for UK interest rates is still 2.0 per cent higher than that of the Eurozone.
No wonder, the balance of buying interest has favoured the Pound over the Euro while the Dollar has declined, and unless there is a marked change in sentiment towards the Euro, that status quo may well remain.
Unless, of course, the ECB or the BOE changes its tune, but then you can’t believe everything you hear, so believe it when you see it.
• David is a Foreign Exchange Dealer with Halo Financial Ltd, delivering competitive exchange rates and a personalised service to help private clients throughout Europe save money and hassle on their foreign exchange. He can be contacted via e-mail at [email protected]