What was supposed to be a day reserved solely for today's nonfarm payrolls report as the biggest news, has been upstaged by the overnight flash crash in pound sterling, which as reported previously inexplicably plunged 6% in a sharp move lower ahead of the Asian open, dropping the most since Brexit...
... with liquidity in pound literally evaporating during the two minutes of chaotic selling, pushing the bid-ask spread surging to more than 250 times their median during the past year...
... and after an attempt to recover all losses has once again resumed its grind lower, dropping to Europen session lows just above 1.23.
And if Deutsche Bank is right, it won't stop there. According to Deutsche Bank, the GBP move has been "shocking", and it will only get worse. The German bank's FX analyst George Saravelos writes in a note to clients that Deutsche Bank expects the pound to revisit lows seen during the Asia session and forecasts GBP/USD to trade at 1.15 by next year.
He also predicts that Gilts should open very weak today as the market not only prices a massive inflation shock for the country but also a higher risk premium; this level of FX volatility should raise the cost of holding any type of sterling asset. Sees currency weakness as a natural rebalancing process.
Saravelos observes that the sharp rebalancing is required to make GBP assets cheap enough to fund the country’s massive current-account deficit in the face of an unprecedented negative terms of trade shock, and adds that negative capital flight - with evidence of a synchronized sell-off of U.K. assets across equities, drates and real estate as foreigners liquidate holdings rather than increase allocations on the back of a cheaper FX - is not DB’s baseline scenario.
Perhaps more importantly, he says that weakness in GBP and related inflation implications make an additional BOE rate cut this year highly unlikely; and instead DB thinks FX intervention is more likely.
Wall Street does not disagree and investor pricing of a BOE rate cut has changed dramatically this week, with the pound’s flash crash overnight stoking market fears of upside inflation risks. The latest plunge in the which has fallen over 17% since the U.K. voted to leave the EU; is likely to push up prices of imports, and may force the BOE to not only put its QE on hold but to join the BOJ in implicitly tapering its QE to push the crashing currency stronger. Already, inflation prints post the vote have shown an acceleration: headline CPI rose 0.6% in both July and August, compared with 0.3% in both April and May. As a result, the market is now pricing in 70% probability of a 10 bps rate cut by June 2017, compared with an almost 100% chance at the end of last week.
To be sure, delighted to have a new financial topic for Wall Street to obssess about, DB says that the pound plunge will make political headlines and is likely to give U.K. PM Theresa May and her team second thoughts on the tone of future statements on Brexit; the moves should also give a greater voice to the “soft” Brexit camp.
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Another perspective comes from Bloomberg's Mark Cudmore whose take on last night's flash crash is that it has been long overdue:
Pounding the Volatility Drum
A sudden 6% drop in cable today highlights that financial market complacency has been rife and investors can expect implied volatility to rise rapidly.
Today was a capitulation point for the pound but that doesn’t mean the currency will now strengthen. As I wrote earlier this week, Theresa May suddenly made “hard Brexit” the overriding theme for sterling traders, temporarily making all other inputs less relevant.
French President Hollande chorused in overnight to ram home the point that a “hard Brexit” is being pushed from both sides. This won’t remain the status quo for the next two years, but it’s what matters right now.
At least all the immediate downside stop-losses in the pound have been filled, and the major option barriers knocked-out. The pull-factor from below has been removed, which will provide the currency with some respite.
Unfortunately for the U.K., 2017 is still set to be a year of slow growth, higher inflation (which reduces real yields), excessive debt and a worryingly large current- account deficit. That’s a toxic combination for the currency until one of those factors alleviates significantly.
So today’s “flash-crash” doesn’t change the sterling game, but it’s a catalyst to reassess the broader volatility framework across asset classes. Whether equities, bonds, currencies or emerging markets, implied volatility measures are all subdued and need to adjust higher.
Traditional havens, such as gold, the yen and U.S. Treasuries have all been sold off significantly in past weeks, which only enhances the misguided view that all is well with the world.
The U.S. election is still very much in play, bond markets are breaking out of their ranges, a Fed hike is becoming increasingly likely, European banks are struggling and the Italian constitutional referendum will add further stress.
Volatility is set to return in style. Today’s sterling move was just a dramatic warning shot across the bow.
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Finally, for those wondering what happens next, here is Credit Agricole's Valentin Marinov asking, rhetorically, when does the GBP-selloff become disorderly:
GBP plunged by more than 6% in the early hours of the Asian trading session before correcting most of the losses later on. Poor market liquidity likely exacerbated the move, which was triggered by President Hollande's comments overnight that signalled an apparent hardening of the French position on Brexit. The FX volatility dampened risk sentiment and weighed on risk-correlated G10 currencies.
The move highlighted the risk of disorderly moves in GBP. Indeed, the FX selloff no longer seems to be taking place against the background of stable or falling bond yields and resilient stocks. The UK bond market has suffered some losses more recently in part on the back of recent criticism by PM May of the impact of the current ultra-easy monetary policy on the economy. The combination of collapsing currency and concerns about fading monetary support for the UK asset markets could stoke fears about balance of payment crisis and disorderly selloff in GBP.
If not contained, the recent developments could have important consequences for the BoE's ability to prop up the economy in a period of heightened uncertainty. Persistent currency weakness and asset market underperformance could trigger capital outflows that are made worse by the UK's sizeable current account deficit. That could lead to unwarranted tightening in the financial conditions (via higher bond yields) and unwelcome rise in imported inflation, which stops the BoE from easing further.
The above being said, we still believe that the fears of an imminent GBP currency crisis are overdone. Indeed, a big part of the UK CA deficit is funded by ‘stickier' FDI flows rather than volatile portfolio flows. In addition, we expect that the sharp GBP depreciation of late should boost the value of the UK foreign assets and thus improve the income account balance – an integral part of the CA balance. Last but not least, despite May's recent remarks we believe that the BoE will remain on course to deliver monetary stimulus if needed. That should help contain any FI selloff.
Over longer-term, markets will continue to worry about the prospects of Hard Brexit. The rhetoric that came from the recent Conservative party conference in Birmingham also added to the fears that Britain is becoming less business friendly. A potential ‘Hard Brexit should lower the UK's potential growth as it could reduce the inflow of productive labour and capital. This could result in even more protracted GBP underperformance.