The new iron cross

A downside of being in the trading business (including the analysis of economic and financial history) for any length of time is the constant reminder of human foibles. Given this author has described the entire history of currencies (going back to the original barter standard) as the financial version of Original Sin, we should be able to take any long dated currency market, look back, and weep.

Another downside, as long as we’re at it, is how little the world’s governments care about market analysts. They have constantly changed parameters, re-based economic time series, added and dropped data reports and — in the granddaddy of all indignities — created the euro. Not that they had much choice in the last matter: The two decades between the adoption of flexible exchange rates with the Smithsonian Agreement in March 1973 and the adoption of the Maastricht Agreement in February 1992 were characterized by one currency crisis after another in Europe.

The use of multiple currencies within a tightly-linked economic zone with widely disparate politics and cultures was an insoluble problem. At best, attempts to maintain currencies within a band involved wildly swinging short term interest rates as nations sought to defend artificial exchange rates. You can fix an exchange rate, or you can fix interest rates, but you cannot fix both simultaneously.

This certainly is visible in the long history of the cross between the British pound (GBP) and the Deutsche mark (DEM) and later the euro (EUR). Prior to 1992, the spread between the Bank of England’s (BOE) base lending rate and the Deutsche Bundesbank’s discount rate was volatile, to say the least. It generally ranged between a 3 to 10-percent premium to the British side, but even this was insufficient to prevent a long slide in the GBP relative to the DEM. The so called Iron Cross fell from more than 6 to a target level of 3, and this target level of 3 DEM/GBP collapsed spectacularly in September 1992 when George Soros and others bet correctly the British Exchequer would be unwilling to keep interest rates high enough to maintain the exchange rate.

The Iron Cross eventually firmed as part of the mid-90s pan-European convergence. Once the DEM was fixed into the EUR in January 1999, the new Iron Cross quieted into a narrow trading range of roughly 2.75-3.00 almost without regard to the relative movement between the UK base lending rate and the European marginal lending rate, the successor to the old Bundesbank discount rate.

Once the EUR came into existence, so did EURIBOR, the LIBOR rate for the common currency. We can compare the forward curve for EURIBOR with Sterling LIBOR, a parallel construct for the GBP. As we have done several times in these columns, we will use the forward-rate ratio from six to nine months (FRR6,9) as the metric for monetary policy expectations. This FRR is the rate at which we can borrow (for three months) starting six months from now, divided by the nine-month rate. The more the FRR exceeds 1.00, the greater the expected degree of monetary ease.

The difference between the EUR and GBP FRRs measures relative expected changes in monetary policy. If the difference is positive, as it was during 2004-2006, the market expects future tightening in British monetary policy relative to Eurozone monetary policy. This relative tightness has helped maintain the GBPEUR cross-rate in its tight range, much like the intentions of the pre 1992 BOE policies. If the opposite holds, as it did throughout 2001, the market is expecting relative ease in British monetary policy. This ease preceded a weakening in the GBP-EUR cross-rate.

Markets are discounting devices: It is not the instantaneous measure that matters so much as the expected measure; no other explanation can explain the tight range of the new Iron Cross.

A similar pattern is evident on the capital market horizon. The rate spread between British and European 10-year notes was quite narrow between 2000 and 2002, the period preceding the sharp weakening of the GBP. Once British yields started to rise relative to Euro yields, the cross-rate stabilized.