Central bank guidance & currency strength

<p>The last 6 weeks have proven that the more detailed a central bank’s forward guidance, the weaker the value of its currency. GBP is the […]</p>

The last 6 weeks have proven that the more detailed a central bank’s forward guidance, the weaker the value of its currency.

GBP is the best performing currency since the 2nd half of the year. Aside from continuing upside surprises in economic data, GBP remains fundamentally superior to EUR and USD due to:

i)             Richer forward guidance

The central bank with the clearest forward guidance has had the weaker currency because it has the greater set of policy options by which to keep interest rates low.

The Fed’s forward guidance is the clearestamong the BoE and ECB in terms of options and variety.  The Fed has managed to de-link tapering from raising interest rates by stating that any reduction in asset purchases could be cushioned by slashing interest on bank reserves. The Fed has pushed prospects of a rate hike farther in the horizon (we expect 2016) after stating that no increase in rates as long as the unemployment is “considerably below 6.5%” and no hike in rates if inflation were “to remain below our 2% objective”.

In the case of the ECB, forward guidance has been limited
to maintaining a downward bias on interest rates and keeping the door open for negative refinancing rate. Yet, even prospects of the latter have diminished after the latest inflation figures from Germany showed a rise to 1.6% y/y from 1.2% in October. Beyond inflation metrics, the ECB has provided little guidance on how to keep rates low.

The BoE faces the most constraints in its forward guidance as it has provided little in the way of guidance apart from setting an unemployment threshold of 7.0%.  The latest upward revision in 2013 growth backs market expectations for an earlier occurrence of 7.0% unemployment (H1 2014 instead of the BoE’s H1 2015).

In Sum, currency traders face the fewest of obstacles from the BoE in bidding up GBP and the greatest in obstacles from the Fed in bidding up USD.

ii) Contrasting central bank rhetoric

The BoE’s main preoccupation has become suppressing bond yields by convincing markets that the economy continues to face slack. Mark Carney’s reference to “extremely weak” wage pressures in the UK is aimed at dampening any inflationary concerns. Yet, robust UK data gave little choice to the BoE but to ease up on its dovish rhetoric.

In contrast, the possibility of negative interest rates by the ECB, and slashing interest rates on bank reserves by the Fed remain dovish

We expect EURUSD to regain 1.3800 due to lack of policy action from the ECB. Any reference to LTRO3 is likely to be EUR-positive as long as risk appetite remains positive. Support remains underpinned at 1.3220s, which is the 55-day moving average.

GBPUSD faces a 4-year trendline resistance at 1.6350, near which it is likely to retrace some ground as we near the taper uncertainty from the December Fed meeting. But the path remains set for a retest of 1.6500, with selling seen emerging at the 200-month moving average of 1.6630. Also note in the chart below, it has been over 2 years since GBPUSD has not tested its 200-month moving average. Previously, the pair has tested the 200-MMA every 3-4 years.  If there is a time when GBPUSD should mount further gains towards this key average, it is today.

Watch Ashraf Laidi’s CNBC interview on central bank guidance & FX

Join our live webinars for the latest analysis and trading ideas. Register now

GAIN Capital UK Limited (trading as “City Index”) is an execution-only service provider. This material, whether or not it states any opinions, is for general information purposes only and it does not take into account your personal circumstances or objectives. This material has been prepared using the thoughts and opinions of the author and these may change. However, City Index does not plan to provide further updates to any material once published and it is not under any obligation to keep this material up to date. This material is short term in nature and may only relate to facts and circumstances existing at a specific time or day. Nothing in this material is (or should be considered to be) financial, investment, legal, tax or other advice and no reliance should be placed on it.

No opinion given in this material constitutes a recommendation by City Index or the author that any particular investment, security, transaction or investment strategy is suitable for any specific person. The material has not been prepared in accordance with legal requirements designed to promote the independence of investment research. Although City Index is not specifically prevented from dealing before providing this material, City Index does not seek to take advantage of the material prior to its dissemination. This material is not intended for distribution to, or use by, any person in any country or jurisdiction where such distribution or use would be contrary to local law or regulation.

For further details see our full non-independent research disclaimer and quarterly summary.