There is still some debate about the low in GBP/USD following its flash crash. Reuters, which used to be the primary trading venue for Cable, printed 1.1491. With FX being a delightful over the counter market, where traders at banks can no longer talk to one another, we will never really know what the “official” low is. But for sure it was indeed a flash crash, coming at the most illiquid time of day, just after the Sydney open.
Various stories circulated, not least the one regarding Francois Hollande’s threat that: “we have to have this firmness … if not, we would jeopardise the fundamental principles of the EU. Other countries would want to leave the EU to get the supposed advantages without the obligations … there must be a threat, there must be a risk, there must be a price … the U.K want to leave and pay nothing, it’s not possible”.
But the truth is that GBP has been under threat for some time. The fiscal position and external deficit are even worse than they were when the UK had to go to the IMF for a bailout in the 1970s. The UK relies on capital inflows and there needs to be a risk premium put onto GBP assets for that.
Sterling has been under pressure all week, ever since Theresa May fired the starting gun on Article 50. Now we know that the 2 year negotiations kick off in earnest by the end of Q1 2017. In five months, we will be well on our way out of the EU. This has clearly focused minds. Hence stories in the WSJ yesterday that “Firms Beef Up Contingency Plans Ahead of Brexit Deadline”, noting that ‘When Japan’s Daiwa Securities Group Inc. heard the British prime minister pledge on Sunday to prioritize controlling immigration in the coming Brexit negotiations, it didn’t wait to act. The next day, staff accelerated contingency planning for the bank’s London investment banking unit and began to contact other European cities, according to a person familiar with the matter. While Daiwa doesn’t have a definite plan yet, it could involve relocating some operations to the Continent’.
We already know that the BOE and the government are relaxed about GBP depreciating; both have said as much in earlier statements. Back in August when the new government arrived and the BOE cut rates alongside publishing their Inflation Report, there was an exchange of letters between Governor Carney and Chancellor Hammond, with the latter saying:
‘You make clear the MPC’s judgement that fully offsetting the persistent effects of sterling’s depreciation would lead to an undesirable loss in output and employment and would be less likely to generate a sustainable return of inflation to the target beyond the three-year forecast horizon….Alongside the actions the Bank is taking, I am prepared to take any necessary steps to support the economy and promote confidence’ – in other words, don’t act to offset GBP’s decline.
The real surprise about Sterling’s fall is the speed and timing of it. That, however, cannot be pinned upon the new government. That is a much bigger issue beyond the UK, beyond Sterling, beyond currency markets. It is a reminder once again of the fragility of the current market structure. There is already a lot of talk about algos. Funny how they are always to blame. But don’t be fooled that “nothing traded”. It’s tough to get volume numbers in FX, but here is a chart of the volumes traded on the Reuters platform. Bear in mind that this is only a small part of the market these days, but something did trade at 1.1500 and a fair amount traded below 1.2000.
So, it’s not as if the market was “dysfunctional” in the sense that it was not showing the right price. Rather it became like EUR/CHF after the removal of the floor, where no-one quite knows where anything is trading, but trading they must do, and the prices become evident later. The difference is that the EUR/CHF market was always skewed up for something nasty, given all the option barriers sitting below a level that the SNB said they would defend until the death with their “unlimited” intervention. If we have now seen price action that is similar to that period, without such a skew in the market, then it suggests the underlying market is even more fragile than it was then.
This would tie into the view that liquidity is an illusion, with the absence of banks as warehousing risk takers, and the increase in high-frequency trading. Note that the official report into the US Treasury flash crash noted an unusual amount of “self-trading” when the 10yr yield crashed – that’s algos trading with themselves.
The point then is that the world is now in uber risk-seeking mode, with various risk indicators such as the VIX trading at benign levels; there has been a loading up into yielding assets; but we now have signs that “Lower Forever” is coming to an end. The BOJ needing to sell JGBs for their Yield Curve control, with a sniff of ECB tapering, and a Fed hike in Dec priced at 60%. This GBP flash crash is a reminder that the endless liquidity is coming to an end much sooner than the market cares to realise.