The forex report for Nov. 19

British transparency underscores sterling’s value

The forex story has become a subsidiary one to the performance of the equity market, which in turn is playing second fiddle to the day two “we need – more money” discussions on Capitol Hill. Rest assured that currency implied volatility remains just as does the elevated reading of the VIX. Selling volatility these days in the expectation of a sea change anytime soon has been eradicated from many currency investors vocabulary. It appears that the currency markets are lining up like dominoes and those investors can see the patterns lining up in front of them. They can see more clearly what will set off a decline where and have some sense of magnitude as to how far things can run. The dollar remains bid for its safe haven status. The yen remains the safety valve against equity market losses and neither currency can lose much more in terms of yield.

As we noted last week the race to zero in terms of how fast other central banks can slash rates is likely to help rather than hinder currencies. Note the difference in reaction to the release of minutes this week on Australian and British units. The Aussie dollar declined when its central bank confirmed that its earlier 0.75% cut in rates was intended to work towards rate neutrality. It also said that intervention to buy Aussie dollars in exchange for US dollars wasn’t aimed at supporting just the domestic unit, but to assist other currencies as well. That leaves the Australians hampered by high interest rates with investors proving willing to short currencies where they believe economies will be left high and dry as the global recession moves ahead. Further, there are no guarantees that the RBA won’t intervene again, but even if it does it appears to admit that it’s trying to smooth any advance in the US dollar and spur liquidity rather than to set a floor beneath the Aussie.

On the other hand, the pound is sharply higher today against the dollar following the release of minutes from the Bank of England’s MPC. Earlier this month the committee shocked the world by slashing interest rates by an unprecedented 1.5% taking British interest rates below those of the European Central Bank for the first time since the euro currency was launched in 1999. Even when the ECB cut later that same day, a 50bp cut meant rates were 25bps above the British.

In the latest minutes, the MPC discussed the potential for a 2% cut at that time in order to address the impact of the current climate, which was clearly deteriorating and to address the prospect of future deflation. The committee voted unanimously to slash rates but withheld some of the cut until after the government had revealed stimulus to the economy via reductions in fiscal policy. The bottom line is that the market clearly perceives the BoE to be a far more progressive central bank than ever before. They see further reductions in rates and a deeper understanding of the challenges facing them.

What strikes us most at this point is that in recent weeks the bare face approach adopted by the British was deemed a weakness and led to a huge punishment for the currency. Now, investors understand its comprehension and desire to reach zero in rate terms sooner rather than later. This has earned credibility for the Bank and is being felt in the performance of the pound, which is the firmer by the largest amount vis-à-vis, the dollar at $1.5225. Interestingly implied volatility on the Aussie unit at 36% remains unchanged on the week while that on the pound has slumped from 25 to 23%.

If this move on the pound isn’t subtle enough, try looking at the Swiss. We raised the notion a couple of weeks ago that the Swiss franc, that other victim of the carry-trade, wasn’t fulfilling its task of safe-haven status. We noted the dire circumstances of the domestic banking sector, whose big two banks account for more write-downs related to the US mortgage meltdown than the next four domestic banks combined. The Swiss National Bank has also slashed rates.

At the time, the Swiss franc was behaving in semi-yen like fashion, but was a poor second. At the time, the Swiss was very rising to the surface among European currencies. But lately investors seem to have adopted our thought process, which is that the Swiss is equally toxically tainted as any of its neighbors and possible mired deeper in the emerging and Latin crises. Despite the euro’s weakness against the dollar, the Swiss is these days finding itself equally pounded and worse still the euro is outflanking the Swiss franc. In conclusion, we are shocked to see that Swiss implied volatility at under 15% means that the Swiss franc is getting away with murder. In reality, it’s no better than anyone else and once investors finally realize this it will be no surprise to see a sharp rethink in volatility terms.

Since Nov. 12, only the euro has gained some ground against the dollar and stands at $1.2662 up from $1.2509. The Canadian dollar and Swiss franc share the dubious honor of being the week’s biggest losers – shedding 1.5%. However, the relative stability of the forex market has allowed some deflation of volatility readings. So even with a weaker Canadian dollar for example, its implied volatility reading is lower by some 17% while that on both euro and pound is down sharply by over 20% respectively.

With the exception of the pound, open interest in currency futures dropped sharply last week as the dollar’s advance clearly shook some investors out of the game. The build in sterling open interest is further evidence that futures traders are coming around to understand that the race to zero in respect to interest rates is likely to benefit the pound. Meanwhile, open interest in the Canadian dollar was worst hit as investors shed 11% of their open positions. The declining price of oil hurts exports and we must remember that oil exports comprise 10% of Canada’s export value.

Andrew Wilkinson

Senior Market Analyst

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