In 2005, the U.S. dollar rebounded as interest rates prompted a 14.5% rally in the Dollar Index. As we round the corner into 2006, interest rates will continue to be a dominant driver of currency movements. However, shifting trends in interest rates will make new currency pairs more attractive carry trade opportunities in the year ahead. With diverging monetary policies, the euro and British pound provide a particularly interesting pairing.
Even though the Euro Zone and the U.K. are but a stone's throw away from each other, their monetary policies are like night and day. The Bank of England became one of the first G7 central banks to raise interest rates in late 2003. They commenced an aggressive tightening cycle that brought interest rates from 3.50% to 4.75% by late 2004. The European Central Bank (ECB) on the other hand, has left interest rates unchanged at 2% since June 2003. Now the tables are turning however, as the ECB gears up for its first rate hike in two and a half years.
The Bank of England on the other hand has already become the first major central bank to lower rates, 25 basis points in August of 2005. More rate reductions are expected in 2006 from the Bank of England, which should keep the sterling relatively depressed. Taking a look at the figure below, there are several points of interest that show the power of changing interest rate expectations. The red line is the EUR/GBP price while the blue line is the three-month Euribor rates minus the three-month short sterling rates. Point A shows a dip in the spread between Euribor rates and short sterling rates back in March, in favor of the British pound. This coincided with a six week sell off in EUR/GBP. The spread began moving in favor of the euro in late June (point B), which coincided with a 300 pip rally in EUR/GBP.
Since then the spread has gradually continued to increase to the euro's favor while EUR/GBP has predominately remained range bound. Should the spread continue to widen as it is expected once the ECB raises rates and the Bank of England moves closer to its next rate cut, the EUR/GBP should move higher as well.
Kathy Lien is chief strategist for www.dailyfx.com.