The fact that one of the world's reserve currencies can fall 6% overnight is a clear sign of the supply/demand mismatch that is taking place in GBP. Our Global FX Strategists Yujiro Goto and Jordan Rochester look at this movement and the factors affecting it.
“Flash crashes” don’t tend to signal the end of a trend
It’s tempting to think that the flash crash may be the moment when GBP turns around or at least finds a base as the dust settles in the market. However, quite to the contrary we found that in the top 10 and even top 20 “flash crash moments” in GBP/USD since 1988 the flash crash was no more than a sign of the trend that was in place and GBP/USD continued lower.
What was the low in GBP?
The Bloomberg quoted reported low was 1.1752 in GBP/USD (-6.7% on the day) and 0.9298 in EUR/GBP. The actual low remains a big question for market makers (Reuters quotes even more extreme levels for example) but in either case the move was within 1-4 minutes which is very extreme.
Why did the move happen?
It was not particularly headline driven. Instead it was most likely a large sell GBP order amid thin liquidity and an algorithm failure just as GBP approached the 1.26 barrier. To put it into perspective, the only time when GBP has fallen so much so quickly was the Brexit vote result, outshadowing the Lehman default and GBP’s “Black Wednesday” in its departure from the ERM.
What does the GBP fall mean for the BoE?
The GBP overnight fall was not orderly but, given the retracement since, the BoE will take some comfort in the fact it is not trading below 1.20 (yet). For policymakers it’s less the level that matters but instead the pace of the move. If we were to continue to see such aggressive price action to the downside then we’d start to get into the realms of the market expecting some form of policy action. But the moves are still far from the level where FX intervention or indeed a hike to defend the currency would be considered.
How to trade the GBP volatility?
The speech by Theresa May at the beginning of October told us that the timing of Article 50 is to be “no later than the end of March next year.” This provided clarity as to when, but was not much of a surprise given several reports that alluded to that possibility in the weeks prior. The market view the day after was that the big themes of Brexit were touched on and offered little hope of a single market access outcome, given the emphasis on immigration and sovereignty controls used.
GBP continues to be a difficult market to trade, with political headlines causing the recent fall but also a deterioration of wider market risk sentiment perhaps playing part of the trend lower (see Die Deutsche sorge - German worries). If the negative European financial developments continue, this could accelerate GBP weakness, especially against USD, while the US political risk declined somewhat after the first debate (still uncertain, though).
The price action itself is reminiscent of when Boris Johnson came out in support of Brexit in February and when the June date was announced. GBP fell on the Asian open even though risk markets fared well, but really it was from 7am on the Monday when GBP started to fall significantly, and vols head higher taking a week to find a base.
Looking past that, the political uncertainty remains high but it’s hard to see how it can get much worse from here as the market has likely realized the higher risk of Hard Brexit now. We are unlikely to learn of anything material apart from the aims stated already until the negotiations start.
What next for sterling? We are going to be monitoring the three following events closely:
Article 50 legal challenge to be heard 13 and 17 October. A two-day hearing, with the opportunity to extend the length of the hearing, will take place in mid-October.
UK Q3 GDP first estimate (27 October). A growth rate of 0.0% would be in line with the August BOE projections and, thus, in line with the view to cut at the November meeting. Our GDP tracking estimates suggest an upward surprise is likely.
BOE QIR meeting (11 November). Q3 GDP and the data around it will set the tone going into the BOE meeting. From where we are now, it would take a more severe outlook change in the data for the BOE to act again, in our view.