Pound and Euro: Under Pressure

Mid Week Bond Update

Pound and Euro: Under Pressure

While the rising dollar has been getting all the attention, the British pound and the euro have been surprisingly resilient in the face of significant pressure.


Pound and Euro:  Under Pressure

Since the end of October, the pound has been up as much as 3.1% against the greenback --  up as high as $1.31 per pound before ending the period at about $1.285, up 0.5% vs. the beginning of the period.[1]  That surge and retreat have been attributed to traders’ mood swings as the news flow from Brexit waxes and wanes, along with mixed but positive pre-Brexit economic news

The euro had a similar but less decisive surge, rising only 1.6% against the dollar to a peak $1.15 per euro. However,  the currency is currently below its starting point at about $1.123 – down roughly 0.7%.

Euro and British Pound: change in value relative to U.S. dollar (indexed to 100), Oct. 31- Nov.12, 2018
 

Source: Bloomberg, November 12, 2018. Past performance is no guarantee of future results. Indexes are unmanaged, and not available for direct investment. Index returns do not include fees or sales charges. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment. * Chart shows percent appreciation/depreciation since Oct 31, 2018, 3:00 PM ET, based to 100 at the beginning of the period.

However, the euro faces several challenges that could hold back the currency.  Italy’s budget faceoff with the European Commission shows little sign of compromise on either side, with the possibility of a banking crisis in Italy lurking in the background. In addition, the European Central Bank (ECB) appears committed to begin the dial-back of its epochal bond-buying program in the latter half of 2019, despite the relative lack of the energetic growth the European economy would need in its absence.

On the Rise: U.S. Dollar-Euro Carry Trade

As the divergence between the U.S. and  European bond market continues, the yield differentials between the two now present an opportunity for traders to benefit from the “carry” between the two.

“Carry”, of course refers to the return that traders can generate by “carrying” net positions in one currency vs. another to exploit differentials in shorter-term interest rates.  In this case, the opportunity lies in the record 3.47 percent differential between two “safe haven” rates: 2-year U.S. Treasuries and 2-year German government bonds.  

This rate arbitrage is more easily seen than captured, and sudden currency moves could erase the difference – and more. In addition, the differential could easily contract as central bank policies change.  But the Fed appears committed to further raising its benchmark rates, and the ECB is clearly not ready to tighten aggressively -- which could leave this differential in place, even if currencies moves based on other reasons were to blunt this source of income.

On the Slide: Costa Rica

Costa Rica’s economy, at an estimated total size of some $61 billion in 2017, doesn’t have much impact on the overall universe of emerging market economies.  And its industrial base is largely composed of U.S. companies taking advantage of generous tax incentives in its free trade zone.   

But these tax incentives, as well as other government subsidies, come at a cost. The country’s budget deficit has been growing steadily as the cost of providing services has grown, and as those generous tax incentives fail to generate other income for the government.  The increasing use of the U.S. dollar as its de facto currency has also exerted pressure on the country’s bonds.

For example, the country’s five-year U.S. dollar bond, with a 4.25% coupon, traded low enough this month to produce a yield of 8.11%, a record high. The country’s currency, the colon, has fallen some 9.6% since the end of August; in a setting where the government prides itself on its control of the exchange rate. and the central bank raised its rate to 5.25%, partially in response. Moody’s Investor Services projected that the country’s debt load could rise to more than 50% of its GDP, and has put the country’s sovereign rating on review for a possible multi-notch downgrade.

 

[1] Source for all data -- Bloomberg, November 12, 2018


Definitions

Carry refers to a differential in interest rates across sectors, such that tactical profits could be generated by trading between them.

 

 

[1] All data Source: Bloomberg, November 12, 2018

 

[1] All data Source: Bloomberg, November 12, 2018

 

[1] All data Source: Bloomberg, November 12, 2018

 
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