The Pound is Losing Weight
By Ed Ponsi
Hello from New York! It seems that one of my comments from last week's article confused the heck out of a few folks, and that's not surprising because it goes against conventional Forex trading wisdom. Please take a look:
Q) Hi Ed, just a quick question regarding your newsletter, I found it great. You explained in the last few lines that 'When the ECB and the Bank of England get serious about growth and cut rates more deeply, expect to see these currencies recover'. Is it not true that currencies get weaker if the interest rate is lowered? Can you explain what I am missing? Look forward to reply.
Q) It has always been my understanding that when there are rate cuts, the currency tends to weaken, not recover. It seems that the UK and EU have a lot farther to go with regards to rate cuts and therefore, the currency has more potential to weaken than the US dollar. Is this still the case?
Ed Ponsi) Thank you for your questions, it's nice to know that someone is paying attention! You're both right, conventional wisdom would say that higher rates would support the Euro and the British Pound, yet I stated that rate cuts were needed to improve the weakness we've seen in these currencies. Have I lost my mind? Not completely, but that's a question for another newsletter.
In a normal market, I'd agree that conventional wisdom would apply, and that lower rates would hurt the Pound and Euro – but the situation we find ourselves in is anything but normal. The fact that the Euro and Pound have higher interest rates than the U.S. Dollar has done nothing to prevent them from being crushed over the past three months, and currencies with even higher yields, like the Australian Dollar and the New Zealand Dollar, have been equally bad (unless you're short). In the current Bizzarro World of Forex trading, it is the low yielding currencies that have taken center stage as the strongest currencies, and the high yielders that have fallen the hardest – the exact opposite of normal Forex activity. Here is the current interest rate environment for the major currencies:
Currency
Interest Rate
New Zealand Dollar 6.5% Australian Dollar 5.25% Euro 3.25% British Pound 3.00% Canadian Dollar 2.25% Swiss Franc 2.00% U.S. Dollar 1.00% Japanese Yen 0.3%
Consider this; the two best performing currencies of the major currencies during the third quarter have also been the two with the lowest yields – the U.S. Dollar and the Japanese Yen. In the U.S., the Fed Funds Rate sits at 1.00%, and is expected to fall to as low as 0.5%. Meanwhile, the Bank of Japan has lowered rates to 0.3%. Yet the greenback and the Yen have been crushing everything in sight - it's the carry trade in reverse!
Here's the way I see it – all of the above countries are going into or are already in a recession, and the policy of keeping rates relatively high in Europe and Great Britain is going to lead to an even deeper recession in those places. Mervyn King and Jean Claude Trichet, the respective leaders and chief policy makers of the Bank of England and the European Central Bank, seemed unduly concerned about inflation at a time when growth should've been the major concern. But as we will see next, that view is changing...
Q) Hi Ed. Wow exactly it happened!
"If the entire civilized world is falling into a recession, why is the Pound taking it on the chin? The Bank of England's Monetary Policy Committee has simply been too slow to cut the U.K.'s benchmark interest rate, which remains at 4.5%. The MPC's reasoning is that it must control inflation, but with world markets collapsing and crude oil falling below $70 per barrel, the pendulum has shifted and the time for action has come. In my opinion, the MPC should immediately be cut by another 150 basis points, but that's highly unlikely. I'm looking for more downside on the Pound."
You know what I feel today, I think King Mervyn has signed up for your newsletter and he's simply following you. Just kidding, anyway what is your opinion now on GBP after their rate cut? Thanks, keep up the good work.
Ed Ponsi) Thanks for your email and your kind words. The big rate cut by the Bank of England shows that King and the Monetary Policy Committee now "get it", however belatedly, and that the problem is not inflation, it is growth. In a complete about-face, King now says he is ready to reduce rates to 'whatever level is necessary' to counter the economic storm. Some even believe a zero percent rate is possible in the U.K. next year. That's a far cry from his "fight inflation" mantra from earlier this year. Don't be surprised to see the BoE cut by another 100 basis points as they try to get on top of the growth problem – a problem that would've been less damaging if they hadn't fallen behind the curve earlier. The damage is reflected in the daily chart of GBP/USD, which continues to spiral downward (see figure 1).
Figure 1: GBP/USD continues to probe new lows, crossing below 1.5000. Source: Saxo Bank
How low will it go? Nobody knows for sure, but I certainly wouldn't recommend stepping in front of this freight train. A look at the monthly chart shows big support at 1.4000, formed way back in the early part of this decade, which could come into play (see figure 2).
Figure 2: GBP/USD monthly chart shows a major support near 1.4000. Source: Saxo Bank
Last but not least, the GBP/JPY currency pair, one which we've been bearish for months, continues to plumb the depths and is also threatening to reach new lows (see figure 3).
Figure 3: Descending triangle on GBP/JPY suggests new lows are coming. Source: Saxo Bank
Once again, don't fight the trend. Good luck!
