Sebastian (aka New but Eager to Learn Forex Trader)

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Dear Sabastian,

The best way to think of the relationship of the EURGBP,  is as if the US did not exist.

The EUROZONE and the UK have a trading relationship with each other and as such when a currency gets out of line versus another it can cause that currency pair to move. Fundamentally, a strong EURGBP would imply that EUR growth will be stronger and as a result, there is demand for its currency. It may also be that the market thinks the country will raise rates faster or it may be that the EUROZONE has higher rates and this is attracting buyers of its currency at the higher interest rate (carry trade).  It might even be a worry that the US dollar will not be the reserve currency in the future and this caused the EURO to be bid up versus the GBP (and USD).

Whatever the fundamental reason, the currency pair goes up. Then one day, the story changes and the market decides that the high EURGBP is making Eurozone exports too expensive in the UK and as a result, the currency is too high and must come down. Alternatively, the strong EURGBP may now make UK imports so cheap in the EUROZONE that it forces domestic producers to lower their prices to be more competitive. This may actually lower inflation and may lead to disinflation.  It may be that the thought that the EURO may become the reserve currency starts to lessen or it may be that the stock markets start to fall and the best place to be is still the US dollar.

Whatever the reason the price of EURGBP starts to come down because the fundamentals of yesterday are reversed today.

Another fundamental reason for a move might be simply that a EURO company may be purchasing a UK company and has to buy pounds. Since the pounds are cheap the price they pay for the GBPs may be a key, key ingredient in the equation for the purchase. It may be so important that if the EURGBP goes down to a certain level, the deal would fall apart.

So if EURO Company pays 1 billion for a UK company (or is even thinking of buying a UK company), they have to buy 1 billlion pounds and sell the equivalent of EUROS TODAY. That may also cause a trend in a cross pair like the EURGBP.

Now as the EURGBP price comes down, the traders who trade the pair may need to hedge exposure. One way to do this is to “hedge with the pieces” So say XYZ bank trader gets sold 50 million EURGBP. This is just a piece of what may be 10-20 other trades to banks around the globe – done at roughly the same time. Instead of XYZ bank “shuffling the spaghetti around the plate” and calling up another bank to sell the EURGBP (at probably a wide price at a loss), the XYZ bank trader will look to “hedge with the pieces” – that is by doing EURUSD and GBPUSD.

So if a trader is long EURGBP, and wants to hedge the exposure, the EURGBP Long makes that trader long EUR and short GBP. If they sell EUR vs USD and buy GBP vs USD, they are selling EURO, buying GBP and buying and selling USD (they do the same amount of USD in both deals so as to cover that exposure). The USD net out and the trader is left with a synthetic EURGBP that is opposite the original long position.   They are hedged.

With more liguidity in the EURUSD and GBPUSD this can often be done at a cheaper rate than if they did EURGBP directly with another trader at another bank.

The end result, is more pressure on the EURUSD and less pressure on the GBPUSD. That is what we saw today.

If you take this dynamic and throw in a market filled of other traders who have their own agenda in EURUSD, and GBPUSD, and you get a day like today, which to the non expert is “head scratching”. To compound things even more today, the Yen crosses were also on the move (EURJPY, AUDJPY down) and key technical levels were being tested and breached along the way for a number of pairs.

On a scale of 1-10 this is a 10 as far a “degree of difficulty trading days”. If you steared clear, you did well. If you just watched the EURUSD, the trend down was your friend – hopefully you were short. If you understood this dynamic of the cross trade, you could have done well (but even then there is this feeling that something is not right with the world). If you were selling GBPUSD because EURUSD was moving lower and GBPUSD kept going higher, it probably was a horrible day. Take solace in knowing it does not always happen this way.

I hope this helped in a small way and if you did know that the more you learn, the better off you will be.

Greg Michalowski 

You might be interested in:

• Best FX Links: December 01, 2011 (stocktwitsfx.com)
• Spread Trading And Takeovers (thisisbigger.com)
• Stocks: Investors take Greek deal in stride (CNNMoney.com)