Forex Investment and Currency Trading

During the financial upheaval of the last year, measures of central bank policy neutrality have not been a useful guide to future policy changes. Central banks, the Fed in particular, have maintained policy stances far out of line with those that would be dictated by growth and inflation fundamentals. But the increasing focus on inflation risk around the world has changed this, with “normalisation” of interest rates again
starting to become a useful concept. With the updated measures of the current stance of policy in the G10, look for potential anomalies in the current pricing of rate expectations.

There is no perfect measure of the appropriate level of “neutral” interest rates, but Taylor rule rates have the attractive qualities of being simple, objective and easily comparable across countries. Taylor rule rates start from the notion that, over a whole economic cycle, the appropriate interest rate is equal to trend GDP growth, plus the central bank’s inflation target. This long term equilibrium is then adjusted for the cycle using a 50/50 mix of the output gap and current inflation forecast relative to target.

All other things being equal, we would expect yield curves in those countries with the loosest policy stance to discount most central bank tightening and those with the tightest to discount most cuts. While two year yields are clearly vulnerable to local market anomalies (supply for example), they are largely clear of the credit issues that currently plague interbank rates and associated futures and FRAs and are probably currently the best compromise for cross-country comparisons of rate expectations.

Shifting value in the peripheral Europeans- buy NOK/SEK

Based on the analysis, one of the key thematic trades for 2008 was to be long the European periphery (CHF, SEK and NOK) and short the core (EUR and GBP). This strategy has worked well, delivering a near 6% return year-to-date. But the SEK leg of this trade in particular now looks stretched, with market rate expectations no longer too low. In contrast, Norges Bank could deliver rates hikes that go far beyond the two priced into the forward curve. On relative rate grounds, long NOK/SEK looks like the better trade currently. Switzerland is not dissimilar to Norway and it is highly likely the SNB will act on the tightening bias implicit in the
statement that accompanied this week’s unchanged rate decision. In contrast, both the Eurozone and UK curves price in too much tightening.