Currency Corner
Take a look now at table 2 below which depicts the Bank of England base rate. You will see that it is essentially a flat line at 0.5% since 2009 — testimony indeed to just what a sorry state the UK economy has found itself in recent years... The important point here however is that accepted currency theory tells us that, in the short term, “interest rate differentials” are a key driver of currency movement. On this basis the pair should have been rising in the last 18 months. In the long term, it is “inflation differentials” that definitively do move currency pairs. Well, back in 2009 when the interest rate differential was at the same levels (2.5%), the average FX rate between the pair was in fact approaching $2 to the pound. More evidence of a “wrongly priced” FX rate.
CHART - BANK OF ENGLAND BASE RATE HISTORY It is widely accepted by economists that the PPP (purchasing power parity) fair value for the GBPAUD pair is indeed anywhere between $1.95-$2.20. Consider then also table 3 below which depicts the monthly inflation rate in Australia since Jan 2009 and also table 4 which charts the same measure for the UK. The UK has experienced an average inflation rate of around 3.5%, whilst the Australian economy has experienced inflation average just under 3%. Per currency theory, then the pound should have depreciated against the Aussie given the small inflation differential, but certainly not anywhere near that which it has — some 20%+.
“In the early part of 2013, Australia posted its widest trade deficit in nearly five years — generally an ominous sign and precursor of currency weakness.”
78 | www.financial-spread-betting.com | February 2013