Thursday, March 27, 2014

Economics, inflation and spare capacity | Our Forex positions

There is one thing that can be regarded as having the best chance of taking the British pound above the strong resistance it has met in the form of the Monthly 200 period Simple Moving Average (SMA), (illustrated here), and that is a rise in UK interest rates.

The thing that is keeping UK interest rates low at the moment is a flat inflation figure. The desire of the authorities would be to increase inflation, not too much of course, but enough to dispel any fear of deflation. And what keeps inflation low is spare capacity. The classic way to illustrate the relationship between rising prices, which are invariably driven by wage demands, and inflation, is the Pareto Efficiency curve.

In the diagram above, and according to the traditional model as used by economists, a country might have the desire to produce both guns and butter. If it is not fully efficient, in other words if it is not at the limits of the curve in the diagram in terms of its ability to utilize all its resources, it can choose to make more butter even while it keeps gun production stable, because it has spare capacity and all that is required is that it ups its levels of efficiency. However, if it is at full capacity and cannot become any more efficient, it can only produce more butter at the expense of making fewer guns. This happens when production effort reaches the line of perfect efficiency in the diagram above.

It is therefore easy to see how an economy working at full capacity can lead to inflation. Workers will demand higher wages and can, in effect, choose whether they will be involved in butter production or the manufacture of guns. Just as interest rates are a primary driver of currency rates, wage demands are a major factor in the rise or otherwise of inflation. And when inflation increases the authorities have an incentive to raise rates.

This is the kind of analysis tool we use here at OmiCronFX in order to inform our decisions on currency pairs. There are many others of a similar nature.

Our positions

Gold continues to perform for us and a reading through recent commentaries will show the evolution of our position in the precious metal. The Aussie dollar is still defying gravity, but that is OK as we do not hold a position as yet, and will not do so until the Mandelbrot routine determines that it has started to fall in value, either against the US dollar or the New Zealand unit (NZD), or both.

Mandelbrot took us out of our position in the Japanese Yen (USDJPY) last night (GMT) as it was going nowhere and the Yen actually strengthened (USDJPY went down), apparently in response to a falling Nikkei index. We have entered a short position in EURGBP, which is currently heading nicely in the right direction, and we watch GBPAUD in the belief that the Aussie will eventually weaken while the pound will appreciate. Neither of these things has happened as yet, however.

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