Euro and British Pound Crushed by Rate Decisions

The Euro and British pound have come under severe selling pressure after the ECB and BoE cut interest rates by 50bp. Interest rates are now at historic lows for both central banks and even though the rate announcements were negative for both currencies, the Euro has sold off more aggressively than the British pound because ECB President Trichet warned that growth will be signicantly reduced in 2009 and 2010 while inflation will remain well below 2 percent.

More importantly, he admitted that the ECB is studying non-standard measures which include quantitative easing. However, Trichet prefers to use the Fed’s label of credit easing over quantitative easing (What is the Difference Between Credit and Quantitative Easing?). The mere possibility that the ECB could consider Quantitative Easing was enough to drive the EUR/USD below 1.25. With the third highest interest rate of the G10 nations, further interest rate cuts are still possible. By saying that they have not made a decision about whether 1.5 percent is the lowest level makes 1 percent interest rates a real possibility for the Eurozone. In fact, Trichet may opt for another rate cut before credit easing. For the US dollar, British pound and Japanese Yen, no surprises are expected from future rate decisions. However for the Euro, the prospect of lower interest rates and the uncertainty of if and when the ECB will adopt credit easing should keep the EUR/USD under pressure.

Bank of England: Rates May Have Hit Rock Bottom

As for the Bank of England, I believe today’s 50bp rate cut to 0.5 percent is their last. The central bank has been worried that excessively low interest rates would erode profitability of banks, reducing their incentive to lend. Now that they have been given the authorization to begin Quantitative Easing, it will be their new focus. UK Gilts have soared on the announcement that the government will purchase up to £100bn in Gilts and £50bn in private sector assets (syndicated loans and ABS). As we indicated in our ECB and BoE preview, Quantitative Easing is negative for a currency, but if the BoE is done cutting interest rates, further weakness in the British pound may be limited.

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4 Comments

  1. FreedFX
    Now is a great time, as you can only make money if there is volatility in the market. Just don’t let yourself be exposed to tail risk

    One good way to limit tail risk (ie fat tails, excess kurtosis, black swans) is to trade FX using options.

    However, if you trade the spot, trade the trend (mean reversion works!) on fundamentals, keep your leverage low, have patience, and don’t trade the noise. (Zoom out to 1 and 3 year views to see the trends you should be trying to identify.)

    The great thing about studying for FX is the knowledge can be applied to other markets, and you can add diversity (and increase your Sharpe ratio) by trading other markets. For example, it should be obvious from both sovereign and corporate CDS rates that you should be short fixed income, as interest rates should be rising as default risk increases

    Reply

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