Saturday, December 08, 2007

Event Risk, Interest Rates, and Central Banks.

The various reporters in the foreign exchange markets like to play up what they call "event risk", but I suspect it's just a ploy keep the interest of their readers, to keep them returning regularly. There were a couple of cases in point this week including the Bank of England meeting, the European Central Bank meeting, and the non-farm payroll figures from the USA.

Admittedly the Bank of England cut their interest rate targets in a move that those same reporters called, "a bold step", or "a surprise move", and the value of the pound sterling declined because of the rate cut, but only to levels that were common for most in the second half of 2007.

In this case the markets were in fact surprised and anyone long the Pound ahead of the meeting faced substantial risk. At this point FXB may be yet another way to diversify away from the US Dollar or the Euro (FXE).

In direct contrast to the Bank of England, the European Central Bank also met on Thursday and elected to maintain target interest rates at 4%. This was widely expected and in one article some 72 economists were polled in advance of the ECB meeting and all had the same opinion. The relevant data points are widely known because there is a constant stream of data coming from all the national members in the Eurozone. Inflation is rampant throughout the zone, mostly because of energy and food costs, but economic output is still growing and German unemployment rates are at post-unification lows.

This unparalleled access to information tends to eliminate the event risk when trading the Euro, and that can be shown graphically by directly comparing the above FXB chart with the chart for FXE.

There are none of the wide swings in the FXE chart, such as what is seen in the FXB chart, and I strongly suspect that is because little to no event risk exists. In fact, the FXE chart shows an incredible series of higher highs, and higher lows. I'm sure an Elliot Wave chartist would have a field day on that one. There is a simalar series in the FXE 2-year weekly chart, and I feel strongly that the Euro will soon resume it's steady rise against the dollar. There are also fundamental reasons for that, including one I described in a previous post.

The last item in our news items this week was the Non-Farm Payrolls. NFP is widely watched because it is forward looking and helps to predict consumer spending in the coming months. Consumers are able to spend more if they are employed, or better employed than in the past. This weeks number was a goldilocks numbers and was widely expected because of a similar labor report earlier in the week. In fact, trading yesterday was one long boring affair in the equities and exchange markets that I follow.

Ok, "event risk" is real but not universal and while it can produce trading opportunities, I would still contend that reporters tend to overuse the term.

disclosure: I own FXE calls, and will probably be buying FXB calls in the near future.


pythagoruz said...

The FXB chart makes this recent low look alot like the one made back in August. Just looking at the chart, I'd say this is a great place to go long FXB.

But this whole rate cut by the BoE while ECB is hawkish confuses me and it explains the divergence in those two charts. Shouldn't the euro and the pound be closely correlated? You can use euros as easily as pounds in the UK right?

indigo-alien said...

Nope, not at all. You can exchange them easily though.

One of the problems that the UK/Eurozone has always faced is that the UK has a fundamental difference of political/economic thought from the continent, and therefore the business cycles are widely divergent.