The ‘hard Brexit’ story appears to have completely blindsided market participants, who up until now were apparently positioned for a comfy, EEA-type deal that now seems a distant prospect. As a result, sterling has paid the price.
Just about every fear indicator is flashing red for sterling. Options volatility is soaring, bid ask spreads are unstable, and market-implied inflation expectations are skyrocketing. On October 7, sterling experienced a flash crash that drove the currency to a 31-year low. Trading conditions on Friday were the most unstable they have been since the day of the referendum result.
Trading conditions for sterling are the most unstable they have been
since the day of the referendum result
One of the leading explanations for this chaos is that the machines did it. But the often-cited ‘fat fingers and algorithms’ explanation for these events wears a little thin. The reality is, regardless of exactly what happened last week, sterling has been on a relentless downwards trend since June, and Friday morning was merely an extension of that. For what it’s worth, my running hypothesis of Friday morning’s events is that an initial collapse in bids – however it was triggered – was compounded by good old fashioned panic, machine or human.
This raises an interesting question: if the thinking machines are exhibiting behaviour that is, for all intents and purposes, akin to fear and panic as well as greed, does it matter who is pushing the button? Perhaps by gazing long enough into the abyss of the human heart, momentum-following and market-making algorithms have found us staring back at them.
But I digress. There has been a significant and unexpected deterioration in the political outlook for sterling over the last two weeks, so the moves in markets are not without justification. The various speeches, interviews and statements to the media have all suggested the UK is squaring up to a ‘hard Brexit’. This has blindsided markets, which were previously priced for a soft deal that would see the UK retain significant EU market access.
UK Prime Minister Theresa May’s attempts to paint soft/hard Brexit as a false dichotomy ring hollow, when the terms her government have set out strongly suggest the UK will lose a material amount of access to European markets. I’d suggest anyone arguing otherwise takes a look at GBP/EUR’s progress.
At this point, picking a bottom for the pound is an exercise in knife catching. You may get it right and impress everyone with a nice parlour trick, but there’s a greater chance of painting your living room red.
It’s not clear how much of Friday morning’s sell-off was a matter of panic and momentum, and how much it reflects genuine deterioration in the outlook for sterling over the previous week. But what is clear is that the pound is extraordinarily vulnerable at the moment, and the potential for further volatile moves is unusually high.