GBP: After Last Week's Flash Crash, Sterling Slide Not Over?
GBP: Calibrating The Current GBP Decline; What's Next?
The initial sell-off in GBP/USD following the EU Referendum was immediate and resembled the price action in 1992 when the pound was ejected from the Exchange Rate Mechanism (ERM). If that pace of depreciation had been sustained, GBP/USD would have been comfortably trading below 1.20 by now. However, the improvement in UK data (relative to analysts’ overly bearish expectations) has seen GBP/USD stabilize with its current trajectory more reminiscent of the price action during the financial crisis in 2008.
Relative to previous idiosyncratic crises, the current fall in GBP appears to be in its infancy in terms of the number of days from peak-to-trough moves in the pound: 18% of the way through relative to 1975; 63% versus 1992 and 33% versus 2008. A two-year timeline for negotiations once A50 has been triggered will keep GBP under pressure and risks further new multi-year lows. This view is supported by the analysis of previous peak-to-trough moves in GBP/USD through various UK idiosyncratic crises.
On average, GBP/USD has fallen by 30% through those previous episodes. GBP/USD has already fallen by 14% since the Referendum.
Should GBP/USD decline at a similar average monthly pace as it has done since July (-1.3%) until end-2017 and in line with previous peak-to-trough declines, GBP/USD could target 1.05.
This projection would coincide with the 1985 low in GBP/USD ahead of the Plaza Agreement. We must emphasize that this does constitute an official forecast but a projection based on previous idiosyncratic moves in sterling. We had previously forecasted a low in GBP/USD of 1.25 in 2017, but highlighted that the risks were to the downside and the low could be hit sooner rather than later.
At present, and despite the large short, there appears to be little respite for the pound. In cash, we prefer to be seller of sterling rallies but our preferred strategy is to be long GBP volatility.
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Despite the bounce seen after last week's "flash crash," sterling was back on the ropes Tuesday, with traders treating the beleaguered currency like a hot potato.
While market players generally envisioned an eventual recovery for cable, they did not look for a sustained rally to be seen any time soon.
Last Friday, after Thursday's U.S. close and in early Asian action, the pair tumbled wildly from a high near $1.2623 to a low around $1.1838. This was the agreed-upon low by the various platforms, although there were deals purportedly transacted at much lower levels.
The fast-paced cable decline was said to have been triggered by various drivers from "hard Brexit" comments from French President Francois Holland, to talk of a "fat finger" trader, to talk of an algorithm that went "rogue."
The break of the psychological $1.2000 mark was important in that it had been a downside target for some to be seen by year-end, that is, if there were a Fed rate hike and the Bank of England eases rates further.
"We continue to monitor developments in the GBP (-0.6%) with a particular focus on the 1.2228 level in cable," saidstrategists at TD in a note.
"A move below here might reinvigorate selling pressure and embolden investors to test last week's panic lows below $1.20," they added.
Sterling was trading at $1.2118 Tuesday afternoon, on the low side of a $1.2090 to $1.2376 range.
Last month's high was $1.3445, seen before Prime Minister Theresa May's comments suggesting Article 50 will be invoked by March 2017.
The 2016 high was $1.5018, seen June 24 in response to initial Brexit vote headlines that appeared to favor the UK remaining into the eurozone.
The sub-$1.2000 levels lows in sterling, posted last week, were 31-year lows, levels last seen in May 1985. Cable bottomed around $1.0520 in February 1985.
"Exit negotiations may now start in spring 2017," and will be "driven by political and not economic targets," said strategists at Morgan Stanley.
"With 46% of exports from the UK being sent to the EU, the UK may have to pay a high economic price for this strategy," they said.
Accordingly, sterling "may have to fall further from here to compensate for this self-imposed uncertainty," they said.
JP Morgan's Paul Meggyesi observed that cable's decline of late occurred "despite a still very positive data flow."
"The dominant drivers of GBP instead are the concerns that a harder Brexit will do more damage than investors had hoped to longer-term growth and thereby aggravate the UK's balance of payments challenges," he said.
JP Morgan has lowered its end of 2016 forecast for cable to $1.2100 from $1.3200 and raised the euro-sterling forecast to Gbp0.97 from Gbp0.87.
"The one-year forecasts are changed from $1.33 to $1.29 and Gbp0.90 to Gb0.93," Meggyesi said.
On the prospects of FX intervention by the Bank of England, he reminded "there is little the authorities can do to arrest disorderly price action as net official FX reserves are only Gbp27 billion, or just under 1.6% of GDP."
This would scarcely fund the UK's sizable current account deficit for three months, "and would be exhausted relatively quickly in the face of any form of sizable capital repatriation," Meggyesi added.
BNPP's CLEER model indicated the "worst-case" scenario for sterling is currently priced in, said BNP Paribas strategist Michael Sneyd.
"In previous periods of economic or financial slowdown (1991, 2001/2 and 2008/9), the UK's BBBoP reached extreme lows of around - 10% of GDP," he said.
A return of the UK's broad basic balance of payment to such a level would correspond with cable trading around $1.35, the CLEER indicated.
"Incorporating an ongoing large impact of the BoE's QE programme, the 'worst-case' level for GBPUSD is around $1.22, i.e. close to the trading level in recent days," Sneyd said.
Offering a bigger picture view, Carl Weinberg, chief global economist at High Frequency Economics in Valhalla, NY, saw the latest leg lower in sterling as "an extension of a bigger depreciation that started in July 2014 - long before Brexit became part of the conversation."
Sterling peaked around $1.7192 in mid July 2014.
"The decline in commodity prices has impaired Britain's capital inflows," most notably from OPEC nations and Russia, which were "needed to finance the runaway current account deficit that also pre-dates Brexit," Weinberg said.
"Sterling's crash is a consequence of the commodity price crash, not the flash crash last Thursday and not Brexit jitters," he said.
Accordingly, HFE viewed the UK current account deficit "as the most adverse fundamental for the pound," both in the near-term and long-term.
HFE also saw the BOE's decision to ease further in August as doing more harm than good.
"To the extent the QE and Bank Rate cut undermine an already flawed pound sterling, maintaining emergency conditions when there is no emergency is harmful," Weinberg said.
"We expect a U-turn on QE before the program is completed and we think the Bank rate cut may be reversed by early next year," he said.
In the meantime, sterling will be "at risk of major disorderly adjustments," Weinberg warn.
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