By Mario Sant Singh
Amid the ongoing European debt crisis, the British pound has emerged as one of the unlikely safe-haven darlings for currency traders.
The pound has strengthened 3.4 per cent against the euro since the start of the year, and 7.4 per cent if measured from October last year.
To many traders, this is surprising, considering two major points.
First, Britain is going through its second recession in only three years.
Second, the Bank of England (BOE) has flooded the financial system with pounds through its quantitative-easing (QE) programme, to the tune of £325 billion (S$656 billion).
The main function of QE in any country is to lower yields by purchasing a large amount of securities (through expansion of the money supply).
Lower yields would then help to push interest rates down and, subsequently, boost lending.
All this is done in the hope that increased lending will give the economy a needed boost and, ultimately, stimulate growth.
With the unprecedented amount of cash injected by the BOE, coupled with the flight to safety of European traders and investors, it is not difficult to see why yields are at a record low.
In fact, according to the latest figures on British bonds - known as gilts - yields for 10-year gilts are already below 2 per cent, a record low.
In essence, the flow of funds from Europe is helping the BOE with another QE programme.
BOE is taking a hawkish tone for two reasons. First, the flow of funds from Europe actually "helps" BOE maintain its QE programme.
Second, inflation is still stubbornly high, although it is not being caused by stronger demand.
Although we see the pound strengthening in the currency market, we need to be mindful of the underlying factors behind the currency's strength.