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The Sterling Crash Was Less Mysterious than It Seemed

Posted by Joseph Trevisani on Oct 10, 2016 7:32:28 PM

Several strands went into sterling’s 6 percent plunge against the dollar in early Asian trading last Friday.

The market view of the pound has been negative since the June 23rd vote to leave the European Union. That opinion has been darkening as the tenor of the pending exit negotiations becomes harsher. The Federal Reserve is threatening to raise rates in December, exacerbating the rate differential with the Bank of England which cut rates in August and is committed to cushioning Brexit with liquidity.  

Yet none of these trends were a new development. The fundamentally negative view of cable in the currency market does not provide an answer for the execution on Friday morning.

The primary facilitation in sterling’s collapse was the lack of liquidity to absorb the frantic barrage of selling. There are only two possible answers, either the liquidity on Friday morning was far less than usual or the selling was far greater and more concentrated.  There is no third choice.  

The early hours in Asian currency trading, after the close in New York and before the main markets open in Tokyo and Hong Kong, have always been notorious for sharp violent moves. The liquidity deficit is as old as the broker mediated markets of the 1980s and is a well-known trading risk.

But there is no reason to assume, nor is there any evidence, that the liquidity available in the early hours of Friday the 7th was any different, no more and no less, than normal.

The type of selling that overwhelmed the market can come from several sources. A surprise development in economic, political or financial conditions can instantly alter market assumptions. The adjustment to the new reality can be brutal. The best example is January 15, 2015 when the Swiss National Bank dropped its peg to the euro. In 15 minutes the Swiss Franc soared 28 percent top to bottom and 18 percent on the day against the dollar.

The second instance of violent movement can occur when orders, usually based on technical levels, accumulate around a particular price, compounding trading as all seek execution at the same time and temporarily overwhelming liquidity.

Technical analysis is a commodity. It produces the same conclusions for everyone. If a bank or trading firm has a large volume of orders at a particular level, the chances are most other market entities do as well.   

It is possible that on the 7th a large number of selling orders had been placed below 1.2600.  Since there is no market wide exchange in currencies and orders and flows are proprietary, we cannot know if order books were rife with selling waiting for the sterling to move through 1.2600 for execution. We cannot know, but we can surmise.

No prior technical analysis pointed to 1.2600 as a likely stop-loss liquidation level for long sterling positions. Indeed after the events and market action of the last three months, it is unlikely there were many long sterling positions left.  Nor is 1.2600 a believable technical entry point for a market wide short scenario. Although cable had closed lower in four of the previous five sessions there was no price logic indicating 1.2600 as a crucial level. Sterling had not been there in 31 years. The efficacy of technical analysis across three decades is nil. Without the reassurance of technical analysis it is unlikely that there was a broad market conviction that 1.2600 was a good point to establish a short sterling position regardless of the general feeling that short was the direction of choice.

That bring us to the final possibility.

While it improbable that the market as a whole had chosen a 1.2600 entry point, it is entirely possible that an individual firm, hedge fund, or trading operation had determined that this was a point of maximum psychological pressure.

The sterling price action that morning, from 1.2600 down to 1.1841 then back to 1.2361 in ten minutes, a 6 percent loss and a 4 percent recovery, is typical of a large selling order that instantly retraces as soon as the selling pressure is spent.  

When a firm wants to maximize the effect of a large market order to drive prices as far as it can in the desired direction with the least effort, which is precisely the point of this type of trading, the early Asian market, with its limited liquidity is the opportune moment for execution. 

Consider sterling’s fundamental position that morning. The currency had already lost 15 percent to 1.2600 and no one could tell where the bottom might be. The negotiations with the EU were turning acrimonious and the Bank of England, an opponent of separation, was prepared to keep the liquidity flowing.  Near and medium term prospects were deteriorating.

Consider the trading position. There would be few if any buying orders below 1.2600 to impede the fall because after 31 years there were no relevant technical levels and, after the recent collapse, who would  indulge that most dangerous of  trading endeavors, picking a bottom. The market was ripe for a panic sale.

The results speak for themselves.  Sterling closed on Monday at 1.2362, 2 percent below the 1.2600 entry, enough to provide a hefty cushion for a short positon that may have begun its  execution two and a half figures higher. 

Now it is always possible that the panic on Friday morning was caused by an inadvertent order, the proverbial magic finger.  But such large and perfectly timed mistakes are rare. Market logic points to a far more prosaic source, a well-planned and profitable speculative execution. 

 

Joseph Trevisani

Chief Market Strategist

WorldWideMarkets Online Trading

Charts: Bloomberg

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