Forex Investment and Currency Trading

• Relative rate dynamics point to GBP/CAD falling further from current 15 years lows.
• In the case of GBP, weakness is likely to be compounded by diminishing policy credibility.
• Rallying back month energy futures (gas as well as oil) add to the case for selective long CAD positions.

Rate dynamics point to GBP/CAD lower

Although this week’s smaller than expected fall in UK April retail sales challenges the expectation of an August MPC cut, rates strategists remain convinced that the next UK rate cut is merely a question of timing.

Policy credibility adds to the case

Beyond simple interest rate spreads, questions over the credibility of UK policy add to downside GBP risks. In particular, GBP has developed an asymmetric relationship with expected interest rate spreads against a range of currencies, including CAD. What was once a stable and predictable relationship between expected short-term interest rates and the GBP/CAD cross seems to have broken down. Since September, the forward rate spread has opened up significantly in GBP’s favour, but GBP/CAD fallen to a 15-year low. In reality, the relationship has not entirely broken down, but rather become asymmetric.

In the period prior to September 2007, the correlation between GBP/CAD and the expected rate spread was 0.90. Post September 2007, the correlation fell to zero. However, if we split the data into episodes of widening and narrowing rate spreads, the most recent sub-period looks rather different. Post September 2007, the correlation between GBP/CAD in periods of widening rate spreads is actually marginally negative (i.e. GBP falls when rates rise), while during periods of narrowing rate spreads the correlation remains as high as 0.50 – diminished, but still significant.

Thus, from the GBP side of this currency pair, lower rate expectations remain negative for GBP, but higher rates have ceased to be positive. This is rational in the sense that UK rate expectations are rising not as a result of a better activity background, but rather despite a worsening activity background and as a result of a growing perception that rising inflation limits the scope for the BoE to do anything about it.

In this context, note the contrasting market reactions to the April inflation data in UK and Canada, both of which were significantly above market expectations. On the 13 May (UK CPI release day), after the briefest of rallies, GBP ended lower against both EUR and USD. CAD, in contrast, rallied strongly after Statcan reported an unexpected acceleration in core inflation this week.

Energy prices reinforce bullish CAD stance
Aside from interest rates, further support for CAD comes from recent commodity market developments. The migration of the oil price rally along the forward crude curve implies an embedded expectation that the spike in prices is moving from transitory to permanent. Two year forward WTI now trades at a USD1.20/bl premium to the spot price, compared to the year to end-April average of a USD7.10/bl discount. Moreover, the rally in long-dated energy prices is not confined to oil. Forward natural gas prices (actually more important than crude for CAD) are also rallying strongly.