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Central bank moves give reasons to long euro-pound

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Last week I discussed the new forward guidance that the Bank of England and European Central Bank initiated. I said I thought it would push both currencies down. But which currency is it likely to push down more?

I think the pound. There are two reasons. One, the UK has more flexibility on monetary policy than the ECB does. Secondly, the UK has some balance of payments problems that the euro zone doesn't. But of course it all depends on whether we have another political or economic crisis in the Eurozone. If we do, then the pound will once again be seen as a "safe haven" and will probably appreciate relative to the euro.

(Read More: Why Central Banks must 'promise to be irresponsible')

The ECB lacks flexibility on monetary policy for two reasons. One reason is cultural: the German influence on the ECB. Germany had a terrible experience with hyperinflation during the early 1920s and ever since has had a stable currency as a major economic goal.

When the ECB was set up, it was designed as a replacement for Germany's central bank, the Bundesbank. That's why it only has a single mandate: to keep inflation under control. Secondly, the way the ECB operates in the money markets makes quantitative easing effectively impossible, which limits what it can do. I'll explain why in a moment.

In the U.K., however, they now have a new central bank governor – Mark Carney – whom the Chancellor chose specifically because he wanted someone who would be able to experiment with new ways to support the economy through monetary policy.

Carney's innovative monetary policy when he was Governor of the Bank of Canada fits well with the Bank of England's "triple mandate," which is to deliver price stability "and, subject to that, to support the government's economic objectives including those for growth and employment."

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Accordingly, the Bank of England under Carney is likely to be more aggressive in finding new ways to loosen monetary policy than the single-mandate ECB would. Of course, Carney has only one vote on the nine-member Monetary Policy Committee, and six of the members have shown themselves to be quite willing to vote against the Governor, so he won't be able to do whatever he wants.

But he is likely to try to do more and therefore to succeed in doing more than his ECB counterpart Mario Draghi.

This graph shows that EUR/GBP is closely correlated with the expected difference in real short-term interest rates in two years between EUR and GBP. Note that this is real interest rates, that is to say, interest rates adjusted for inflation. That means if expectations for euro interest rates start to rise before expectations of U.K. interest rates do, or, since this is real interest rates, if U.K. inflation goes up relative to euro zone inflation, then EUR/GBP would be likely to rise, too, meaning the pound would weaken relative to the euro.

I think it's likely that the Bank of England gives longer and more convincing "forward guidance" than the ECB does and that the market is likely to expect U.K .rates to rise later than Eurozone rates. Also, since the Bank of England has more or less abandoned its inflation target, it's quite possible that U.K. inflation will rise relative to Eurozone inflation.

(Read More: ECB's Constancio sees long period of slow euro zone growth)

Secondly, the Bank of England has a much greater ability to expand its balance sheet than the ECB does. The Bank of England operates in the markets the way most central banks do, by buying bonds from the market. It can buy however many bonds it wants if it's willing to pay enough.

But the ECB operates by lending money to banks, not by buying bonds. If banks don't want to borrow money, then there's nothing they can do, especially with rates so low already.

This graph, which shows the ratio of the Bank of England's assets to the ECB's, shows that the Bank of England's balance sheet is already growing faster than the ECB's. Generally speaking, when the BoE expands its balance sheet faster than the ECB does, EUR/GBP rises.

(Read More: How it happened: Markets, ECB and BoE decisions)

The other reason I think the pound will weaken vs the euro is because of Britain's intractable current account problem. Britain has had a current account deficit for many years, and it's getting worse.

The EU on the other hand now has a current account surplus that's getting larger as imports in the periphery collapse. In order to fund this growing current account deficit, Britain has to attract more and more capital. But how will it do that if inflation is rising or interest rates are lower than other countries? That's going to be a challenge for them, in my view, and may cause the pound to weaken. Meanwhile the euro zone, for all its faults, doesn't have that problem at all.

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Of course, a million things could disrupt this scenario. There's a lot of embarrassing news coming out about the Spanish government; if the Spanish government falls, the euro could take a hit. One Italian economist said the country only has six months before it would have to apply for a rescue package, which would be a disaster. Greece…well, Greece is always just a step away from the brink.

So there's a lot of unknown risks in the euro zone. But if we look just at the economic factors that we can forecast, they favour a weaker pound over the medium term, in my view.

The EU on the other hand now has a current account surplus that's getting larger as imports in the periphery collapse. In order to fund this growing current account deficit, Britain has to attract more and more capital. But how will it do that if inflation is rising or interest rates are lower than other countries? That's going to be a challenge for them, in my view, and may cause the pound to weaken. Meanwhile the euro zone, for all its faults, doesn't have that problem at all.

The author is the Head of Global FX Strategy at IronFX, an on-line trading firm specializing in Forex, CFDs on U.S. and U.K. stocks, and commodities. He was previously Head of the Forex Committee at Deutsche Bank Private Wealth Management.

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