U.K. Inflation Should Accelerate And Push EURGBP Lower

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Includes: DRR, ERO, EUFX, EUO, FXB, FXE, GBB, ULE, URR
by: D. H. Taylor

Summary

Worldwide inflation is pushing upward faster.

U.K. inflation will increase and push the hand of Bank of England.

U.K. economy and Bank of England will outpace European Union.

Inflation around the world has been coming in a little more lofty than anticipated. We received U.K. inflation rate last week, and my expectation was that the trend would continue with higher year-over-year increases. This pushed British government bond yields slightly higher.

Whereas the EU has been progressively pushing yields lower from their quantitative easing (QE), in Great Britain, the Bank of England has let off the gas from pushing reserves onto banks' balance sheets. The differential for interest rates favors the United Kingdom over the EU. The corresponding interest rates are 1.90% for the United Kingdom versus -0.4% for the European Stability. Any release that looks to move interest rates higher in the United Kingdom only serves to increase the differential between the two economies. Here is the chart on the differential between the two, along with a second chart showing the slight differential of the two economies' inflation rates:

Inflation in both zones is increasing. In Great Britain, inflation has moved back up to the average over the past decade. In the United States, inflation moved from 0.8% in July all the way up to 2.7% in the most recent release for February. Core rates are slightly muted, but the trend is indicative of what is happening around the world, save for China. The inflation picture in Great Britain closely mirrors inflation in the United States and other economies around the world.

At its last meeting, the Bank of England left its key interest rate with no change. That was expected. It hinted to the fact that there may be room to raise interest rates in the near future. I can see that.

It might be that Brexit, which is now slated for March 29th, may have been good for GB to some degree. But, Brexit has yet to materialize, so until there is actually a change in it, maybe we have no idea what the outcome will look like. For now, Markit manufacturing data for both U.K. and EU have both been positive and increasing significantly.

The British Pound Sterling is effectively 20% discounted to the levels seen just before the June vote to leave the economic union. That means that British products have a competitive advantage via increased terms of trade. This is showing up in factory and manufacturing orders in the United Kingdom. That is a small saving grace. But, my expectation is that these continued terms of trade are going to push Great Britain to outperform the EU even further. Interest rates in the United Kingdom will rise sooner and quicker over the progress of rates in the EU. Keep in mind, the ECB is still mired in its latest quantitative easing and that is slated to continue throughout the end of the year.

EURGBP has been mired in a sideways trend. I favor a move lower since I believe that the cross got knocked out pretty hard from the referendum. I have been selling short EURGBP often over the past several weeks. It has been a trade that has worked out multiple times. I do not hold for large moves. Instead, I am looking for a 1% move downward in the cross. The economic data continues to favor the U.K. over data we see coming out of the EU. The cross tends to sell off whenever there is a piece of economic data released by Great Britain. That data typically reiterates that eventually, the cross will move lower.

My preferred method of shorting this cross is to sell a risk/reversal, although you could go plain vanilla and just short the spot market. Considering the current level of EURGBP, a 1% move lower would be about 80-90 pips, a decent move from the current levels of about .8600.

You are looking for a move higher in the 90-day forward in GBP while simultaneously a standstill 90-day forward rate out of EUR. The differential will push the favor of GBP over EUR, meaning, EURGBP will go lower off of this news release.

I am selling calls with about a 30-delta, buying a 25-delta put. Theta is the same and the trade ends up being a push on the bid/offer cost for the puts versus what you are credited for your short call option position.

Taking a short side of the EURGBP has been profitable for me the multiple times I placed the trade over the past several months. I have been able to achieve my goal of holding the position and earning the 1% move lower. I am working under the thesis that the move higher in EURGBP was way overdone. While the United Kingdom is likely to see some altered imbalances after the initial divorce, overall, it is my belief that the Britain will be able to achieve a balanced trade agreement between Brussels from Article 50.

In FX trading, everything is relative. Despite a short EURGBP position, which is a belief that GBP is moving higher, I am not going long GBPUSD. In fact, GBPUSD could be going either higher or lower.

I am going short EURGBP, which is a synthesis of seeing both EUR and GBP move in the same general direction versus USD, just at different paces. The move higher of EURGBP was far too high. The recent lows for EURGBP are going to break through and, eventually, I will ride this short trade for a much larger move than just the 1% I have been targeting.

Look for continued moves lower in EURGBP.

Disclosure: I am/we are short EURGBP.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.