Week In FX Europe: Euro Rate Divergence Helps Forex

by: Dean Popplewell

By Dean Popplewell

Rate divergence is the key to unlocking forex's twin problems of lack of volatility and volume. Investor interest in FX trading has waned ever since Central Banks started pursuing a "lower for longer" interest rate policy. Current G10 monetary policy has basically handcuffed market direction, influencing their own domestic currency values to their own economy's advantage - in effect a "soft" covert currency war. However, the possibility of real rate divergence is attracting market interest, increasing volatility and opportunity.

The fact that the ECB has finally decided to throw its "whole" tool kit at deflation and growth concerns, in effect easing monetary policy, will eventually lead to greater interest rate divergence, especially against a more hawkish Central Bank like the BoE and the Fed. For sustainable volatility, CBs are required to tighten and until the BoE or the Fed actually hikes, the market will help to extend current low volatility and a market searching for yield (EUR/AUD, EUR/NZD). With the EUR curve now trading through Japan's, the single unit is becoming the primary funding currency of choice.

The Fed remains on track to end tapering by October/November of this year. The US with sustainable growth has the fixed income market pricing the first possible Fed hike at the end of Q1 or beginning of Q2, 2015. However, data like Friday's US producer prices unexpectedly falling in May on the back of costs declining across the board will only complicate the picture for inflation watchers. The May numbers (-0.2%) slipped lower from April's +0.6% m/m gain. Analysts caution that the Labor Department revamped the series at the beginning of 2014 to include services and construction, only adding to the inherent volatility of the measure.

On Thursday, Governor Carney at the BoE caused a stir in the currency markets, hinting that the first rate increases could come sooner than the markets are expecting. Cable has since spiked and is testing the psychological £1.7000 level. Many are beginning to price in a BoE hike as early as this November, which also happens to be an inflation report month/quarter. It's been suggested that Governor Carney will cut the number of meeting dates before the bank will begin to hike rates. This will do two things:

  • Limit excessive speculation over the rate cycle.
  • Strengthen the BoE's forward guidance that rate hikes will be limited and gradual.

On tap for next week:

Central Bank rhetoric again takes center stage, followed closely by UK and Canadian inflation reports. The start of the week we get the release of the Aussie Monetary Policy meeting minutes. In hot pursuit on Wednesday, the FOMC delivers its economic projections and statement followed by a press conference. The SNB fixes its Libor rate on Thursday - no change expected. Ending the week from a central bank perspective will be the BoJ's Governor Kuroda speaking Friday morning.

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