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The Bank of England (BOE) released its latest Inflation Report last week (February 13, 2013). During his remarks and responses to questions, Mervyn King again explained how the current and expected weakness in the economy of the United Kingdom comes from the economic malaise in the eurozone, the U.K.'s largest trading partner. I have always taken these claims to mean that the BoE expects protracted weakness in the eurozone and likely is not getting excited about Mario Draghi's claims for a second half recovery in the collective zone overseen by the European Central Bank (ECB). When King emphasized that the BoE is ready to continue to ease, it further emphasized the precariousness of the situation:

policy stance is already exceptionally supportive of output. Interest rates are close to zero and the Bank's balance sheet has expanded by a factor of five since before the financial crisis. Expressed as a share of GDP, the increase in our balance sheet since 2007 is greater than that in the United States, Japan or the euro area. But, if necessary, we will do more. At its meeting last week, the Committee agreed that it stood ready to provide additional monetary stimulus if warranted by the outlook for growth and inflation.

King provided a one-two punch when he described the limits of monetary policy by essentially saying that monetary stimulus does not create incremental or new growth, it pulls forward the growth that would already have occurred in the future:

…there are limits to what can be achieved via general monetary stimulus - in any form - on its own. Monetary policy works, at least in part, by providing incentives to households and businesses to bring forward spending from the future to the present. But that reduces spending plans tomorrow. And when tomorrow arrives, an even larger stimulus is required to bring forward yet more spending from the future. As time passes, larger and larger doses of stimulus are required.

Needless to say, the British pound (NYSEARCA:FXB) fell swiftly in the wake of the Inflation Report. The release of the BoE minutes provided follow-through selling on February 20th. The net result is a British pound on the ropes, teetering on the presumed support from a trading range I assumed would hold for most of this year.

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The pound breaks down versus the U.S. dollar

(Note that the Federal Reserve released the minutes from its last policy meeting later in the day from the BoE release).

Now that the British pound is in full retreat, my eyes gaze next upon the euro (NYSEARCA:FXE). The euro has benefited mightily from a change in sentiment and a faith in Draghi's word. If the pound tumbles on expectations for protracted economic malaise, I have to believe the euro will follow. Here are the comments King made during the Q&A session about the link between the U.K.'s fate and the eurozone (emphasis mine):

The two factors which have held back the improvement in the trade deficit that we might have hoped for are, first of all, a clear deterioration in the external trade position on financial services, and secondly, of course, slow growth in the world economy, particularly in the euro area. So it's a difficult challenge to rebalance the economy externally when the rest of the world is growing slowly, particularly your single largest trading partner.

King even went on to suggest the eurozone weakness is at the CENTER of global economic weakness:

What we certainly hadn't expected in 2010 was the worsening of the conditions in the euro area…the underlying conditions were obviously adverse there. But market sentiment deteriorated a lot and that clearly impacted on real economic conditions there. And that, as our single biggest trading partner, impacted not just on us but on the rest of the world and the whole world economy has slowed down more, so that world demand has been a good deal weaker than we had expected.

The euro has had a very strong run against the pound, but it now looks VERY vulnerable to a notable pullback. Assuming the pound will soon stabilize against the U.S. dollar, this currency pair seems the best way to play a return to weakness in the euro. I would have suggested the Japanese yen (NYSEARCA:FXY), but I think it is still too early to count on the looming reversal in the currency's weakness to generate consistent enough behavior. Note that the euro has already broken down against the U.S. dollar.

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The euro looks like it is long overdue for a pullback against the pound

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The euro has started to breakdown against the U.S. dollar

The moves in the pound and the euro seem to be part of a sudden shift in the currency market to reverse the trends and assumptions that traders have come to comfortably rely upon for the past several months. Even the dollar index (NYSEARCA:UUP) seems ready to burst higher as it closed on Wednesday above its 200-day moving average (DMA).

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The U.S. dollar attempts a fresh breakout above its 200 DMA resistance

Source for charts: FreeStockCharts.com

If the dollar index manages to break above its highs from November, I expect the current shifts in the currency market to accelerate if they are not already in the process of accelerating by then.

Be careful out there!

Source: Where The Pound Has Fallen, The Euro Should Soon Follow

Additional disclosure: In forex, I am short EUR/GBP and EUR/USD