Britain's euro entry debate is hotting up again following the launch of notes and coins in the single currency, but investors see too much uncertainty to start making bets that membership will actually happen.
Analysts said market participants were certainly talking about how they might make money from possible British membership of the euro zone but the lack of any clear timetable still meant they were not ready to stake their cash on it.
"Most of our clients don't believe in the UK EMU story. The time is not right for convergence trades," said Jesper Dannesboe, head of foreign exchange research at Dresdner Kleinwort Wasserstein.In recent days, Swedish and Danish leaders have indicated they are likely to hold referendums on euro membership next year, adding to pressure on Britain to follow suit or find itself the only remaining "out" in the European Union. Investors have been much more enthusiastic about trying to lock in profits that could rack up if Sweden signs up to the common currency bloc, as they consider that much more likely.
For anyone convinced both Sweden and Britain would soon become part of the euro zone, selling sterling for Swedish crowns would make a lot of sense, on the assumption the pound is overvalued versus the euro and the crown undervalued.
"That would be a great trade but the sterling leg just doesn't work at the moment," said Dannesboe.
BUT EURO ISSUE STILL CAPS POUND
Investors have reservations about whether Britain will join the euro zone because the economy is out of kilter with that on the continent, no date has been set for a referendum, and public opinion remains hostile to membership.
However, the issue is still acting as a cap for the pound against the euro. "Spot is definitely one way to play it," said Francesca Fornasari, currency economist at Lehman Brothers. Analysts said selling sterling in the spot market was the most natural reaction to any news that suggested Britain was going to enter the euro zone on the assumption the pound would only enter the euro at a weaker rate. Conventional wisdom holds the pound would have to fall around 10 percent from its current rate of 62 pence per euro if Britain were not to lock in forever its manufacturing industry's current damaging lack of competitiveness. But sterling's persistent strength has made many question whether such a large devaluation is necessary or even likely to be agreed to by the other EU countries, spurring speculation the pound could even wed the single currency at 65 pence to the euro. If so, with forward rates in three years' time (the earliest likely starting point for Britain joining) currently pricing in a rate of 64 pence to the euro, strategists questioned whether there was much reward in chasing sterling convergence plays given the high level of uncertainty involved.
VOLATILITY A POSSIBILITY
Investors betting on the pound joining the euro zone should consider looking at implied volatilities, the market's estimate of future movement potential in a currency pair. Euro/sterling volatilities should fall to zero, much as deutschemark/lira volatility disappeared in the run-up to the single currency's launch in 1999. Investors could also trade the spread between euro/dollar and sterling/dollar volatilities which should collapse to zero if the pound were locked into the common currency. Analysts said there were far fewer opportunities in the likely convergence between bond yields than there were before the launch of EMU in 1999 as British 10 year yields currently offered around 10 basis points more than the corresponding bund. "Where's the trade in that?" said Rob Hayward, senior FX strategist at ABN-Amro. Another place to look is the spread between interest rate futures contracts which should narrow to zero if British EMU entry becomes a certainty. But analysts said that if the pound were to weaken to join EMU, Britain may need a brief period of higher interest rates to offset the potential inflationary impact of a sudden drop in the exchange rate. Still, overall analysts said that a firmer belief that British EMU entry will happen would be needed before convergence plays came properly into fashion.
"It's more of an issue than it was six months or a year ago but it is at the moment a significant second order issue, not a first order," said Steven Englander, global currency strategist at Citibank.
