The Inflation Watch Continues

04/04/2011 9:00 am EST

Focus: FOREX

Eric Viloria

Senior Currency Strategist, FOREX.com

Eric Viloria, senior technical strategist, FOREX.com, shares how he interprets central bank policy and comments as well as other factors in order to establish mid- to long-term FX positions.

Well as investors and traders, we’re all hearing of course about quantitative easing and how that may at some point lead to inflation, but how does that affect you as a currency trader? My guest today is Eric Viloria from FOREX.com. So Eric, how do you monitor inflation or how does it affect your trading decisions in currency?

Well, inflation affects central bank decisions in terms of policy action, so some ways to measure inflation is with the CPI (Consumer Price Index) or the PCE (Personal Consumption Expenditure) deflator, but we know that when inflation gets out of the central bank target ranges, then they’re either going to step up the rhetoric, they’re going to be monitoring it more closely because a lot of the central banks are working for price stability. 

So, an example would be in the European Central Bank. Their target inflation is 2%, so right now they’re above that. They are at about 2.4%, which recently we’ve seen some of the executive board members of the European Central Bank start to step up that rhetoric and say if these rates get out of control, we’re going to take action, meaning they’re going to raise interest rates, or at least hinting to the market that that’s what they’re likely to do, and we see a response in the currency when this sort of talk happens. 

So, they don’t necessarily have to actually act on interest rates, but just the fact that the expectations for action down the road is happening now is driving the currencies.

So what strategy do you implement behind this? Do you wait for them to make an announcement? Do you kind of take a trade before that in anticipation? How do you like to handle that?

This is more of a medium- to long-term strategy, so it wouldn’t be very short term because you can sort of monitor the trends in inflation, and also, you want to know who’s speaking from the Central Bank. 

Some of these central bankers are known hawks, meaning that they’re more biased towards raising rates, so if say, Andrew Sentance of the Bank of the England is talking and he says he’s advocating higher rates, then that might not have much of a reaction at all, but recently we saw another member of the Bank of England, Martin Weale, switch over and say that he’s also in the same camp of higher interest rates.  That had a profound impact on bringing the pound higher.

So I would say look at some of the trends in inflation as well as look at what the stance and bias of the central bank members are in terms of establishing a position to more medium to long term.

All right and we should also probably define, higher interest rates, good for currency or bad for currency?

Higher interest rates are generally good for a currency. If an investor can earn a higher yield on holding assets in that currency, then it’s going to drive more investment into that currency. So if, for instance, a good example would be if you have some cash and you have to make a decision of which bank account to put it into, are you going to put it in a bank account where you are earning 10% or an account where you are earning 5%?
 
Most people would want to put it where they’re earning a higher return, but you also can’t disregard risk too, because while you may earn 10% on your assets at one place, if that bank has a higher likelihood that it’s going to default, then you’re going to want to reconsider; that 5% looks a lot better.

So, risk sentiment is also something to consider. 

All right then finally, the whole European debt issue in Portugal and things seem to keep popping up. Does that affect your view on inflation or the decision making at all?

It affects rates, and the example that we just talked about with higher rates but also greater likelihood of default. We’re seeing that with these sovereigns because they’re charging higher rates but it doesn’t mean that the euro is going to strengthen because they have to pay higher rates on the debt that they’re issuing. 

It means that they’re trying to incentivize investors to buy their bonds, to buy their paper, because there is a higher risk involved with that. So as those yields go up in those peripheral nations, that’s actually a negative for the euro because it’s increasing risk.

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