We noted earlier in the week, the dollar (NYBOT:DXH14) is benefitting in slow motion from signs of economic health in the United States. Nevertheless the expected pick-up in the pace of activity appeared to be once again adding to traders’ conviction in the future value of the dollar.
But if you want a better example of returning yield differentials – expected at least – then look at the British pound sterling. Against the U.S. dollar (FOREX:GBPUSD) the currency is back to its strongest in almost three years. Against the single European currency unit (FOREX:EURGBP), which incidentally is more than holding its own vs. the dollar, the pound is back up to its strongest in a year. The latest jolt higher for the pound stems from a larger than expected decline in the national unemployment rate. The chart plots the rising value of the pound versus the dollar and the declining price of short sterling interest rate futures. Falling prices for short sterling contracts imply rising borrowing costs. The predicted rise in the space of the last week adds up to around 17-basis points, currently implying that by March 2015 the Bank will have lifted the borrowing cost to around 1.00% from its present 0.50%.
Chart – Pound boosted from rising interest rate expectations
The sudden change of heart in the interest rate market has raised appetite for the British pound. At present it appears that the European Central Bank is apt to start a QE program of its own, while the Bank of England is scrambling to play down the odds of a rate rise.
As recently as August and upon the arrival of former Bank of Canada Chief Mark Carney, the Bank of England predicted that it might start to tighten its policy stance should the unemployment rate fall through 7%. Since then it has matched the U.S. experience and fallen further and faster than anyone had projected. In August the central bank said it did not expect the rate to breech its target before 2016. In the three months to November, the level of unemployment fell by 167,000 to 2.32 million. That is its fastest fall since 1997 and is the lowest level since 2009.
However, the Bank now has its work cut out for it. The dramatic selling in interest rate futures markets midweek was hardly stemmed by the release of the latest set of minutes from the Monetary Policy Committee. Members noted within the release that even if in the near future the rate of unemployment fell beneath 7%, there was no need to lift the bank rate. And while its base case remained that timid inflation pressures resulting from the financial crisis would likely persist for some time and that headwinds would likely continue to restrain growth, the market’s reaction tells a different story. Watch this space.