With market focus largely on the resurgence of geopolitical tensions in Iraq, Bank of England Governor Mark Carney’s comments that interest rates might start to rise sooner than anticipated may prove to be game-changing, catching interest rate markets around the world off guard. In reaction, UK fixed income prices moved lower quickly, pricing in the possibility of an earlier-than-expected Bank of England policy change. Mr. Carney’s comments come on the heels of positive employment data in the UK and the expectation for these positive changes to continue to unfold. Economic conditions in the UK have improved quickly and there is some fear of another housing bubble forming, with rising mortgage debt threatening the country’s ongoing recovery.
The markets’ varied reactions to Mr. Carney’s comments highlight the fact that economic conditions are improving at different speeds around the world, creating different time frames for monetary tightening and ample trading opportunities in both the currency and interest rate markets. UK Long Gilts (September 10-year futures) reacted to Mr. Carney’s statement and the possibility of higher interest rates with a move lower but ultimately failed to break through support near the bottom of the trading range seen over the last five months. A break of the current support level would suggest the market’s growing confidence in the increasing likelihood of the Bank of England actually committing to raising interest rates. U.S. 10-year note futures(CBOT:TYU14) also reacted to Mr. Carney’s comments with a move lower, however, with a more measured move. This may reflect the view that on the other side of the Atlantic, the Fed will take a slower and more cautious approach to monetary tightening. In Germany, the Bund traded higher after Mr. Carney’s announcement, ending the trading day just off current highs – perhaps holding on to the fact that the European Central Bank is working on its own monetary easing policy.
No matter what your stance may be on the ultimate onset of monetary tightening around the world, the UK example shows that there are many ways of trading these changes. Three strategies come to mind immediately, including playing the UK Long Gilts outright as well as vs. the U.S. 10-year note futures or Bund/10-years as a spread. Similarly, the currencies of the UK, United States and Eurozone offer plenty of trading opportunities as well.
This year, the British Pound(CME:BPU14) has so far outperformed the U.S. dollar(NYBOT:DXU14) and the Euro, supporting the notion of a very strong economic come-back in the UK (see chart below). To trade some of these relationships, one play that stands out is the British Pound vs. the U.S. dollar, with the spread currently hovering just below the consolidation highs of the last five and a half years. As a rule of thumb, the longer a consolidation range holds, the stronger the ensuing breakout. That’s significant given that the GBP/USD is flirting with a potential breakout from a long consolidation period. Whether or not we see a breakout as well as the eventual magnitude will depend in large part on the UK’s stamina and its ability to continue to outpace the economic strength of the United States. Whatever your opinion may be, futures and options on futures in the interest rate and currency markets of a number of countries undergoing changes in their respective monetary policies provide valuable trading opportunities and ways to test your own economic views.
Source: Bloomberg. Chart shows British Pound futures continuous first contract weekly chart: with the Pound testing 170.43 – the consolidation high of the past five and a half years, we would need a full week above this level to confirm a breakout with a first objective being 200.74, the retracement high from 07/18/2008.