By Howard L Simons

A downside of being in the trading business (including the analysis of economic and financial history) for any length of time is the constant reminder of human foibles. Given this author has described the entire history of currencies (going back to the original barter standard) as the financial version of Original Sin, we should be able to take any longdated currency market, look back, and weep.

Another downside, as long as we're at it, is how little the world's governments care about market analysts. They have constantly changed parameters, re-based economic

FIGURE 1 — THE IRON CROSS, PAST AND VIRTUAL

The GBP steadily lost ground to the DEM despite the Bank of England's maintenance of high interest rates. The "Iron Cross" fell from more than 6 DEM/GBP to a target level of 3 — which collapsed in September 1992 when George Soros and other speculators correctly bet against the pound.

time series, added and dropped data reports and — in the granddaddy of all indignities — created the euro. Not that they had much choice in the last matter: The two decades between the adoption of flexible exchange rates with the Smithsonian Agreement in March 1973 and the adoption of the Maastricht Agreement in February 1992 were characterized by one currency crisis after another in Europe.

The use of multiple currencies within a tightly-linked economic zone with widely disparate politics and cultures was an insoluble problem. At best, attempts to maintain currencies within a band involved wildly swinging short-term interest rates as nations sought to defend artificial exchange rates. You can fix an exchange rate, or you can fix interest rates, but you cannot fix both simultaneously.

This certainly is visible in the long history of the cross between the British pound (GBP) and the Deutsche mark (DEM) and later the euro (EUR). Prior to 1992, the spread between the Bank of England's (BOE) base lending rate and the Deutsche Bundesbank's discount rate was volatile, to say the least. It generally ranged between a 3-to 10-percent premium to the British side, but even this was insufficient to prevent a long slide in the GBP relative to the DEM (Figure 1). The so-called Iron Cross fell from more than 6 to a target level of 3, and this target level of 3 DEM/GBP collapsed spectacularly in September 1992 when George Soros and others bet correctly the British Exchequer would be unwilling to keep interest rates high enough to maintain the exchange rate.

The Iron Cross eventually firmed as part of the mid-90s pan-European convergence. Once the DEM was fixed into the EUR in January 1999, the new Iron Cross quieted into a narrow trading range of roughly 2.75-3.00 almost without regard to the relative movement between the UK base lending rate and the European marginal lending rate, the successor to the old Bundesbank discount rate.

Once the EUR came into existence, so did EURIBOR, the LIBOR rate for

Markets are discounting devices: It is not the current condition that matters so much as the expected condition.

the common currency. We can compare the forward curve for EURIBOR with Sterling LIBOR, a parallel construct for the GBP. As we have done several times in these columns, we will use the forward-rate ratio from six to nine months (FRRg 9) as the metric for monetary policy expectations. This FRR is the rate at which we can borrow (for three months) starting six months from now, divided by the nine-month rate. The more the FRR exceeds 1.00, the greater the expected degree of monetary ease.

The difference between the EUR and GBP FRRs measures relative expected changes in monetary policy continued on p. 32

FIGURE 2 — RELATIVE MONETARY EXPECTATIONS AND POUND-EURO CROSS

The difference between the EUR and GBP FRRs measures relative expected changes in monetary policy between the Eurozone and the UK. If the difference is positive, the market expects future tightening in British monetary policy relative to Eurozone monetary policy. If the difference is negative, the market is expecting relative ease in British monetary policy.

FIGURE 3 — BOND YIELDS AND POUND-EURO CROSS

The rate spread between British and European 10-year notes was quite narrow between 2000 and 2002, the period preceding the sharp weakening of the British pound. When British yields started to rise relative to Euro yields, the cross-rate stabilized.

FIGURE 4 — INTEREST RATE DIFFERENTIALS HAD FAVORED DOLLAR

The 1985 Plaza Accord was a misguided weakening of the USD designed to correct the persistent U.S. current account balance.

FIGURE 5 — THE BOE SELDOM LEADS THE FEDERAL RESERVE

Volatility in the spread between the UK base lending rate and the U.S. federal funds rate declined only after September 1992, when this spread began leading changes in the GBP-USD exchange rate by six months, on average.

(Figure 2). If the difference is positive, as it was during 2004-2006, the market expects future tightening in British monetary policy relative to Eurozone monetary policy. This relative tightness has helped maintain the GBP-EUR cross-rate in its tight range, much like the intentions of the pre-1992 BOE policies. If the opposite holds, as it did throughout 2001, the market is expecting relative ease in British monetary policy. This ease preceded a weakening in the GBP-EUR cross-rate.

Markets are discounting devices: It is not the instantaneous measure that matters so much as the expected measure; no other explanation can explain the tight range of the new Iron Cross.

A similar pattern is evident on the capital market horizon. The rate spread between British and European 10-year notes was quite narrow between 2000 and 2002, the period preceding the sharp weakening of the GBP (Figure 3). Once British yields started to rise relative to Euro yields, the cross-rate stabilized.

Not created equal

The extent to which the Iron Cross differs from the British pound/U.S. dollar rate (GBP/USD) also can be shown in terms of the long-term interest-rate history. Here, the seminal event was neither the Maastricht Treaty nor the creation of the euro, but rather the 1985 Plaza Accord, a concerted agreement to weaken the USD in the vain hope such a move would correct the persistent U.S. current account balance (Figure 4). Two decades after the fact, to say this agreement failed in this regard is a gross understatement. It did, however, succeed in creating violent moves in U.S. short-term interest rates and

FIGURE 6 — COMPARATIVE CONSUMER INFLATION

helped precipitate the 1987 stock market crash, so in fairness it did achieve some results.

After the Plaza Accord, the GBP rose sharply against the USD, but there was no appreciable decline in relative short-term interest-rate volatility as measured by the spread between the UK base lending rate and the U.S. federal funds rate (Figure 5). That volatility declined only after September 1992, when this interest-rate spread began leading changes in the GBP-USD exchange rate by six months on average.

The greater volatility of the UK base lending rate has led many to erroneously conclude the Bank of England is some sort of stalking horse for the Federal Reserve, just as the Bank of Belgium often was for the Bundesbank prior to the introduction of the EUR. Only twice after the Plaza Accord, in June 1996 and again in February 2004, did a BOE rate hike precede one by the Federal Reserve. The opposite is not quite as strong; a prolonged move in one direction by the Federal Reserve often leads a similar directional move by the BOE. This has yet to happen after the Federal Reserve's long string of rate hikes in 2004-2006.

Differential inflation

One of the reasons behind these numerous asymmetric and weak relationships between monetary policies and currency movements is the different inflation rates in the U.S., UK, and Eurozone.

If we compare the American consumer price index (CPI), the British retail price index (RPI), and the Euro "harmonized index of consumer prices" (HICP — can those bureaucrats in Brussels come up with catchy continued on p. 34

Comparing the American consumer price index (CPI), the British retail price index (RPI) and the Euro "harmonized index of consumer prices" (HICP) indicates the British have the greatest endemic problem with inflation. British inflation has exceeded the U.S. rate since 1975 and the HICP since its origin in 1996.

FIGURE 7 — MONETARY POLICY AND RELATIVE BOND RETURNS

Since January 1999 British bonds have the highest total return because of the reinvestment at the higher short-term rates — notice the UK base lending rate remains the highest of the three central bank rates.

names, or what?) over the past three decades (just one decade for the HICP), we find the British have the greatest endemic problem with inflation (Figure 6). It has exceeded the U.S. rate since 1975 and the HICP since its origin in 1996. All else held equal, a higher inflation rate should lead to both higher nominal interest rates and pressure for a weaker currency in their absence. This has been confirmed by historic experience.

Investors' final word

Markets often produce counterintuitive results. We have seen greater volatility in British monetary policy, higher British inflation and a currency seemingly dependent on higher interest rates relative to both the USD and EUR for stability. Sounds like a good place to avoid, does it not?

No. If we take the total return for American, British, and Euro 10-year notes translated back to USD since January

1999, we find the British bonds have the highest total return. The reinvestment at the higher short-term rates — note in Figure 7 how the UK base lending rate remains the highest of the three central bank rates — accounts for this paradox. Which bond had the lowest total return? That would be the American 10-year T-note; the low short-term interest rates of 2001-2005 lowered the reinvestment component.

This greater currency-adjusted return for the British bonds has to be some sort of odd revenge of the Law of Unintended Consequences — a law that repeats itself throughout market history. We can learn all about human foibles from this, but anyone willing to bet an understanding of the self-defeating nature of economic policy will cause decision-makers to cease, desist, and abandon their hubris is likely to lose a lot of money in a short period of time. O

For information on the author see p. 6.

Related reading

Other Howard Simons articles:

"The pros make it look hard"

Currency Trader, December 2006. Are currency traders making life unnecessarily difficult for themselves?

"Currency trends and volatility"

Currency Trader, November 2006.

Interesting insights come from putting currency volatility under a microscope.

"Currencies and conventional U.S. investments"

Currency Trader, October 2006.

The financial media often reports on moves in the stock and bond markets vis-à-vis currency fluctuations, but these relationships might not be what you expect.

"What does the dollar really affect?"

Currency Trader, September 2006.

Find out how stocks, gold, and other markets actually respond to changes in the dollar.

"The dollar and its hidden risks"

Currency Trader, August 2006.

A look at the dollar in light of its recent performance vs. the yen and the euro.

"Of commodities and currencies"

Currency Trader, July 2006.

Analyzing historic market relationships reveals some interesting facts about movements in many so-called "commodity currencies."

"The yen carry trade, currencies, and U.S. bonds"

Currency Trader, June 2006.

The latest source of anxiety for bond traders has some surprising connections to the currency market. Find out the story behind U.S. Treasuries, the Japanese yen, and the Chinese yuan.

"The euro index: The dollar index meets its match"

Currency Trader, May 2006.

A look at the development of a viable — and tradable — euro index.

"The index approach to currency risk management"

Currency Trader, April 2006.

Using dollar index futures to hedge non-dollar investments.

"The yen stands alone"

Currency Trader, March 2006.

The usual rules of the currency world haven't necessarily applied to the Japanese yen. Will that continue to be the case?

"Remember the forgotten currency"

Currency Trader, February 2006.

It's often labeled a "commodity currency," but the Canadian dollar tends to be ruled by other factors. Here's a look at the factors impacting Canadian dollar movements.

"What drives the dollar index?"

Currency Trader, January 2006. Market watchers often point to deficits and interest-rate differentials to explain the dollar's behavior, but analysis shows these factors might not be in the driver's seat after all.

Howard Simons: Advanced Currency Concepts, Vol. 1

A discounted collection that includes many of the articles listed here.

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