GBP Flash Crash

In the (very) early hours of Friday morning the pound took a brief tumble off a cliff. The currency fell from $1.26 to a low of $1.18  against the dollar (according to Bloomberg) before settling at $1.24. That’s a -6.3% drop – significant for an FX market where a 1% movement can be dramatic.

flash-crashpound
exchangerates.org.uk

The graph above shows the crash. The question is, what caused it and why is it significant?

There are a few explanations, ranging from fat fingered human error to dodgy algorithms. Both are somewhat plausible and make good headlines. Asian markets already have weak algorithmic infrastructure, in 2014 they had to reform their regulation on algorithmic trades following a similar crash in equities. This indicates a somewhat underlying weakness in their ability to deal with automated trades triggering instantaneously, and to control the exposure of their markets.

Fat fingers is another good headline, and easy for the masses to understand. The idea is that a trader’s finger slipped, put in a few extra zeroes, and sent the markets into free-fall. I think we’ll get a closer idea of whether that was the case as the markets tick back into action next week, if it’s a large bank they may well put their hands up and admit error. However the largest FX trading platform at 7am Hong Kong time would have been Singapore, and they were just waking up. Not many of the big traders would have been submitting trades that early. Not only this, but other historic fat fingered episodes ended with the markets rebalancing at their previous level. As the graph shows the GBP is still below its height pre-crash.

My thoughts? The markets are pent up with a lot of BREXIT tension. Theresa May came out last weekend with comments suggesting she was placing emphasis on reducing immigration, as opposed to achieving a single market agreement. The markets have interpreted this as a ‘hard Brexit’ and acted accordingly. The pound had already fallen -2.3% pre-crash. My view is that a lot of firms have been hedging against the pound and setting up stop-loss positions, which has been combined with a number of traders seeing short GBP as an easy trade – thus looking for any opportunity for market weakness (whether its an article by the FT.com) to justify opening their position. It was clearly algorithmic, but these algorithms have been programmed to think a certain way and I believe it indicates an underlying fundamental feeling that BREXIT is going to be tough and drawn out. The lack of a full bounce back to pre-crash levels indicates that the GBP will continue to remain weak.

Significance

There are a few notable side affects of a weaker pound. One has been a rise in the FTSE100 equity index, which seems strange on face value but makes sense when you look at the companies comprising the index. Approximately 70% of their revenues come from abroad, so a strengthening of the dollar increases the amount of GBP they register on their accounts, pushing up their value.

A weaker GBP means our exports are cheaper, increasing their demand, but also increases the cost of imports. Therefore we can expect inflation to pick up, providing consumer confidence and spending remains constant.

In terms of monetary policy two scenarios could unfold. If we receive good economic data, and inflationary pressures appear, the BofE may be more likely to hike rates – to stop the economy burning up with inflation. On the other hand if data is poor, the BofE may maintain their stance to reduce rates in December, encouraging investment and spending in the economy. My view is the latter; rates will likely drop again as we turn to monetary policy to assure investors spending and investment will remain strong. As a result FTSE250 companies benefit, as they have higher domestic exposure and will be reassured by the looser monetary policy stance.

The trade is therefore long FTSE100 and FTSE250. GBP will remain weak, but I think calls for parity with the Euro (or even Dollar) are slightly overblown and maybe a bit of a kneejerk reaction from the flash crash on Friday.

-Ed

Advertisements

One thought on “GBP Flash Crash

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s