British Pound Set for a Dunkirk in Currency Wars
Several indicators had been pointing toward stabilization in the pound/euro cross-rate before the final wave down.
Prior to the advent of the euro, the British pound used to be one of the great rock-and-roll currencies; it regularly moved up and down three cents per day as traders speculated how the Bank of England would match the Bundesbank. It has been taking on its stiff upper lip against both the dollar and the euro since the end of July 2012; this was the date when Mario Draghi promised he would do "whatever it took" to defend the euro.
Those who say, "They don't ring a bell at the top (bottom)" have never been to either place. In the case of the pound/euro cross-rate, the bell was rung last Thursday when the 11.14% slide since July was met with a wave of pound-buying. This came on the heels of a sell-off created by the Bank of England's Monetary Policy Committee debating within itself, FOMC-style, as to whether it should engage in more money-printing.
In reality, several indicators had been pointing toward stabilization in the cross-rate before the last wave down and before events such as last Friday's downgrade of the UK by Moody's, the Haruhiko Kuroda nomination for the Bank of Japan (and its effect of weakening the yen against the euro), and the still-unfolding elections in Italy, which have triggered weakening effects against the euro.
While nominal short-term interest rate differentials still favor the euro, relative equity performance in USD terms between British and eurozone stocks started to stabilize by the end of January. First, the pound's weakness made prospective relative returns on British stocks attractive, and they have advanced almost 4% relative to European stocks in USD terms. It is a simple principle: If euro-domiciled investors have to sell euros and buy pounds to invest in UK stocks, then the pound will firm on the cross-rate, all else held equal.
The EURGBP and Relative Equity Performance
Second, the options market also started to point toward a bottom in the pound by the end of January. The excess volatility of pound forwards for euro holders bottomed three weeks into January; excess volatility is the gap between the implied volatility for 90-day forwards and their historic volatility. Euro-domiciled investors who had been buying puts on the pound and/or calls on the euro were liquidating these positions.
Excess Volatility and the EURGBP
A similar effect was seen in the options market's risk-reversal map at 25-delta positions. This is the difference between the volatility for out-of-the-money call and put options on the pound for a euro holder. While the role of the options market for currencies and indeed for other markets is not to forecast but rather to measure, the market's observed change in relative anxiety does indicate the trend exhaustion requisite for a reversal. In a way, it is ringing a bell before the top or bottom is incurred, and for what more could you ask?
The information on this website solely reflects the analysis of or opinion about the performance of securities and financial markets by the writers whose articles appear on the site. The views expressed by the writers are not necessarily the views of Minyanville Media, Inc. or members of its management. Nothing contained on the website is intended to constitute a recommendation or advice addressed to an individual investor or category of investors to purchase, sell or hold any security, or to take any action with respect to the prospective movement of the securities markets or to solicit the purchase or sale of any security. Any investment decisions must be made by the reader either individually or in consultation with his or her investment professional. Minyanville writers and staff may trade or hold positions in securities that are discussed in articles appearing on the website. Writers of articles are required to disclose whether they have a position in any stock or fund discussed in an article, but are not permitted to disclose the size or direction of the position. Nothing on this website is intended to solicit business of any kind for a writer's business or fund. Minyanville management and staff as well as contributing writers will not respond to emails or other communications requesting investment advice.
Copyright 2011 Minyanville Media, Inc. All Rights Reserved.
Daily Recap Newsletter