All of the major currency pairs are trading higher against the U.S. dollar this morning except for the Euro and Swiss Franc. Everyone’s focus is on the British pound today, which soared on the back on the Bank of England’s Quarterly Inflation Report. The BoE dropped its 7% unemployment threshold and significantly upgraded its 2014 GDP forecasts. The prospect of stronger growth validates the market’s expectations for monetary tightening to begin next year. In fact the market is pricing in 60bp of rate hikes from the BoE the end of 2015.
A lot has been written about the rise in sterling today and we will spend more time discussing the outlook for the currency in our note this afternoon but the continued underperformance of EUR/USD has captured our attention this morning. Weaker than expected industrial production contributed to the move but a soft number was discounted because of deterioration in Germany, France and Italy. Instead, the primary reason why euro is falling is because the negative spread between German and U.S. yields has been widening since the Federal Reserve decided to taper for the second month in a row. The rise in 10 year U.S. Treasury yields affects other currency pairs as well but the difference is that yields in Australia and the U.K. for example are also rising rapidly because of their own shifts in monetary policies. With Friday’s fourth quarter Eurozone GDP report expected to show slow growth at the end of last year, euro could be poised for further losses against the U.S. dollar.
The following chart compares the recent price action of the EUR/USD with the German-US 10 year yield spread.