UK Finance ( Discussion about Finance issues in the UK.

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Old May 7th 06, 10:16 AM posted to uk.politics.misc,alt.politics.british,
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First recorded activity by FinanceBanter: Feb 2005
Posts: 464
Default Is the pound in your pocket going to be worth a lot less ?

Perhaps it's time to get your euros in for that summer holiday ?

Currency outlook
Influence of carry trades on sterling

Considerable developments are taking place in the currency markets and
one of them is the influence on sterling by carry trades. The latter is
a strategy where an investor borrows in another country with lower
interest rates and invests the funds in the domestic market, usually in
fixed-income securities.

A move in US short-term interest rates above those in the UK has been a
fairly rare event over the past 30 years, but it has happened again. In
fact, ever since the Monetary Policy Committee of the Bank of England
cut interest rates in the summer of last year, the market has been
discounting it.

Does it matter for sterling that US dollar interest rates are higher?
HSBC Research believes the answer is twofold. The first is dependent on
the behaviour of model funds based on carry trading and the second is
the influence this event may have on overseas deposits held in the UK.
The negative impact on sterling of this event could be quite large.

A popular way in which carry trades operate is by buying a basket of
high yielding currencies against low yielding ones. When US interest
rates move above UK interest rates this will mean that the US dollar is
about to enter the carry trade baskets as a high yielding currency in
place of sterling. From a carry basket perspective and as far as some
model funds are concerned sterling needs to be sold and replaced by US

To be able to evaluate this risk it is necessary to look at the UK's
external position. In both bonds and equities, the UK position is
balanced. However, the large net external asset position in direct
investment is more than offset by an even larger net liability position
in 'other' assets which are primarily short term deposits or so-called
''hot money''.

There are a number of reasons why this liability has grown so much over
the past ten years. First, the UK has benefited from a prolonged period
of strong domestic demand growth, especially when compared to mainland
Europe. Second, UK interest rates have been relatively high, ensuring
strong 'carry'. Third, the UK probably benefited from the perception of
a safe, flexible and respected policy framework that combined
transparent monetary policy alongside prudent fiscal policy. Finally,
the UK was probably attracting money because of London's status as a
major financial centre.

All these factors were important in attracting buyers of sterling.
However, these reasons are disappearing fast. Domestic demand growth
relative to Europe is slipping, the carry argument has all but
disappeared, particularly against the US, and the policy framework is
also coming unstuck with a large and growing fiscal deficit. The UK is
carrying a net deficit on ''hot money'' of over GBP £360 billion or
over 30 per cent of GDP.

Although the net position is important, it is really the liability side
that is of concern. In other words, it is unlikely that UK residents
will pull their assets back from overseas as UK rates fall relative to
the rest of the world. Therefore, it is the liability position on "hot
money" that is of concern as it is that element that is at risk.

Given the net data is the difference between two big numbers, the "hot
money" situation looks even more dramatic when one argues that it is
just the one side of the balance sheet that is at risk. The UK
liabilities in terms of the 'other' category is twice as big as the
liabilities on direct investment, equity investment and bond investment

Another issue is that this category is very volatile. In other words,
not only is the level exceedingly large but the flows are very
volatile. For example, the volatility of the liability flows on ''hot
money'' are nearly six times greater than the flows on direct
investment, five times as volatile as bond liabilities and twice as
volatile as equity flows. There is an enormous liability that is twice
as big as the other asset classes combined and far more volatile.

The market has been discounting US rates moving above UK rates for more
than six months, but now that it is actually happening it may still
have a negative impact on sterling. This is because there may be a
change in carry baskets to replace sterling with the US dollar as a
'high yield' currency.

In addition, and perhaps more importantly, the UK balance sheet is
exposed to a very large volume of short-term overseas liabilities that
may start being liquidated. On both these factors it appears the risks
for sterling are heavily skewed to the downside.

This report was compiled by Peter Calleya, manager Corporate Strategy
and Research, HSBC Bank Malta plc, on the basis of economic research
and financial information produced by HSBC International Bank.

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