Sterling's Resilience: Agriculture Subsidies?

Sterling has been resilient.  At the end of last week, sterling traded at new highs for the year against the dollar, briefly pushing through the $1.63 level.  It is trading about 2% above the multi-year high recorded against the euro in late July.  On the BOE's broad trade-weighted measure, sterling has appreciated about 4% this year.  This performance is all the more impressive when one considers that the UK economy has contracted for three consecutive quarters and the BOE has renewed its gilt purchases (QE).  

Some observers are trying to link sterling's strength to the EU agricultural subsidies of some 3.3 bln euros.  Even though the payment won't be made for a few weeks, the exchange rate will set at the end of the week.  UK is thought to hedge the value through selling euros forward.   While it sounds like an impressive sum, average daily turnover in sterling against the dollar and euro is estimated at $35-$40 bln a day.  The agriculture subsidies could easily get lost in the normal daily flows.

As a short aside, an OECD report released last week found that over the past three years (2009-2011), agricultural subsidies have accounted for almost a fifth of farmers' income in these high income countries.    Norwegian farmers received 60% of their income from agricultural subsidies.  This is the highest in the OECD.  Agriculture subsidies account for around half of the gross income of Swiss, Japanese and Korean farmers.   

In a most challenging time, as countries try to bring expenditures more in line with revenue, some seem more willing to cut minimum wages, or pensions or employment itself, instead of seeking to cut agriculture subsidies.  In 2011, OECD countries spent some $252 bln on agriculture subsidies.  Talk about sacred cows. Developing countries have long complained about these subsidies, but it appears such complaints have been overshadowed by claims of a currency war.  

Returning to the UK, there seems to be some merit in the safe haven explanation of sterling's resilience.  One way that this can be illustrated is by noting the strong correlation between gilts and bunds.  Over the past 60 days they move in the same direction a little more than 90% of the time.    

On the other hand, sterling is correlated with the euro.  Over the past 60 days, the percentage change in the euro and sterling have a correlation of about 0.72.  Over the past 30 day the correlation is a little above 0.80. This means that if one expects the euro to decline against the dollar, sterling may not be a good alternative, even if it holds up marginally better.

That is what is happening. The euro is near two week lows and is flirting with its 20- and 200-day moving averages (~$1.2840 and ~$1.2830 respectively). Sterling slipped through the support near $1.6180 to record a seven day low, but it is well above its 20- and 200-day moving averages (~$1.6080 and ~$1.5770). For its part, the euro is holding above yesterday’s low against sterling, set near GBP0.7940. Additional selling pressure on the euro would target $1.2760 and GBP0.7900.