fx strategy: trading the interest rate new expectations

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MyInvestmentAnalysis.com I Rafael Rosa I Foreign Exchange Strategy

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March 7, 2011

----------------------------------------------------------------------------Foreign Exchange Strategy: Trading the New Interest Rate Expectations

----------------------------------------------------------------------------Buy the Euro

Interest rate expectations are shifting across the globe as more central banks from developed economies

change their tone on inflation. After keeping its short-term interest rate at 1%, the European Central Bank

(“ECB”) led by Jean-Claude Trichet appears to be signaling for rate hikes in the near future.

Two factors support a change in the ECB’s stance on interest rates. After the March 3rd

, 2011 interest ratedecision, Trichet stated that “an interest rate increase at the next meeting is possible, but it is not certain” i.

The change in language by the ECB is similar to its action before the last interest rate cycle. Another

active movement by the ECB supporting interest rate hikes was the increase in the HICP inflation

forecasts for 2011 and 2012 , which were raised to midpoints of 2.3% and 1.7% from 1.8% and 1.5%,

respectively. The ECB’s mandate is to keep inflation close to but below 2.0%.ii

Buying the Euro amid these interest rate expectations is plausible. While the ECB may not raise rates next

meeting, the market speculation is likely to be that they will move to action. The goal is to position as the

market changes its expectations and “buys the rumor”. Until the next interest rate decision, additional

positive data from the Euro zone would act to add more conviction to rate hike expectations.

The largest downside risk for the Euro involves the debt problems in the peripheral countries. It is

something to monitor, but not an immediate concern. Buying the dip in the Euro until the debt problem

come into focus, if it does, is the best strategy. The sovereign issue is also mitigated by the ECB’s

commitment to intervene in the bond markets and be the buyer of last resort in order to keep spreads

under control.

A sign that sovereign issues are becoming a focus again would be the broad selling of the Euro.

Aggressive selling of the Euro-Swiss Franc cross would be an additional sign of fund flows and potential

fear in the markets.

Sell the New Zealand Dollar

The best currency to sell the Euro against is the New Zealand Dollar. The goal is to buy the

strongest projected currency and sell the weakest. At the same time that the ECB is looking to

raise rates, the Bank of New Zealand is considering rate cuts.

New Zealand has suffered from two devastating earthquakes in the last few months. This

affected the economy which saw quarter-over-quarter seasonally-adjusted real-GDP decrease by




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.04% in the last quarter of 2010. Market expectations are for real-GDP growth to also be

negative for the first quarter of 2011.iii

The next interest rate meeting of the Bank of New Zealand is March 10, 2011. The market is

already pricing in a .25% cut in the cash rate to 2.75% as even the Prime Minister has urged the

central bank to cut rates. Overall, the sentiment is very dovish around the New Zealand Dollar.Even in the absence of a rate cut, it still remains that its interest rate cycle is done for now and

that the focus will be to stimulate growth.

One of the reasons that the Bank of New Zealand may refuse to cut rates is due to the recent

elevated inflation numbers. If the upside risks to inflation outweigh the downside risks to growth

by a large amount, the central bank has the incentive to stay put.

Technical Confirmation

Technical analysis appears to confirm the fundamental view expressed above. It seems that price

action has been representative of market participants buying the new interest rate expectations.

Figure 1: EUR/NZD Weekly Chart

The EUR/NZD weekly chart suggests that the cross has cleared an important resistance level onthe daily and weekly charts, illustrated by the gray box (1.8665-1.8840 levels) in figure 1. The

strategy is to buy any dips to the gray zone, especially if price retreats to the 1.87 zone. The trade

remains valid as long as the pair stays above the 1.84 level on a daily-closing basis.

The short-term target for the trade is 1.9250. The medium-term target is 2.00, with the longer-

term target being near the December 2009 level of 2.10, or about an 11% gain from the 1.88




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level. In general, after consolidating for most of 2010 in the 1.70-1.85 area, a long EUR/NZD at

these levels offers a momentum trade with a great risk-reward setup.

Upside resistance is also expected at the 100 weekly moving average (“MA”) currently at the

1.94 zone, and the 200 weekly MA at ~1.9980s.

Alternative way to play European interest rates:

Positioning long in the EUR/JPY is also a good opportunity to gain exposure to interest rate hike

speculation. The cross is highly sensitive to interest rates.

From a technical perspective, the EUR/JPY pair needs to break through 115.60s on the weekly

chart in order for the price action to confirm the upside potential. The targets on the long trade

would be 120 and 127.70s.




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By Rafael Rosa

www.MyInvestmentAnalysis.com

iTrichet, Jean-Claude. (2011). Introductory statement to the press conference of 03/03/2011.

Retrieved from http://www.ecb.int/press/pressconf/2011/html/index.en.html

iiMarket News International. (2011). Update: ECB Staff Raises HICP Forecast For 2011, 2012.

Retrieved from http://imarketnews.com/node/27291

iiiReserve Bank of New Zealand. (2011). A5 Gross domestic product . Retrieved from

http://www.rbnz.govt.nz/statistics/econind/a5/data.html

fx strategy: trading the interest rate new expectations

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