The really, really, really, absolutely must be understood by everybody takeaway from of the pound’s remarkable flash crash on Friday morning, where against the dollar Sterling briefly slipped from $1.26 to $1.15 in just a couple of minutes, is that on a fundamental level financial markets are now dangerously and possibly irretrievably: BROKEN.
Yet over the weekend the financial and mainstream press has been focused on the “collapse” of the pound and other BREXIT related woes, to the extent that the Saturday FT may as well have been entitled “The Pound’s doomed….doomed I tell thee”. Thankfully those of a nervous disposition should understand that over recent years the FT editorial team have proved that their main role in the modern commentariat is to be establishment apparatchiks, understanding apparently little about the important issues which they have been largely wrong or blind about for, well, roughly two and a half decades (Tech, US Housing, CDOs, CDS, Credit Crunch, Interest Rates, Lehman’s, the Euro, Neil Kinnock…..really….Neil Kinnock!?….oh and again…..the EURO….They wanted the UK in the Euro……REALLY!!!)
However the focus really should have been on what on earth caused one of the most important and supposedly liquid and long lived currency pairs in FX history (named Cable after the transatlantic telegraph cable used to transmit £/$ prices from the 1860’s) to behave like a penny stock that has just received an Investors Chron’ recommendation.
You see when a widely read investors magazine tips a small company this can have a profound impact on the price, particularly in the short term. If all of a sudden fifty readers decide to buy a tipped stock, investing an average of £5,000 then all of a sudden you have £250k in buy orders, which will make little difference to Glaxo, but to a small stock that trades an average of, say £10k a day, increasing the daily volume twenty five fold in the first ten minutes of the trading day will tend to drive a stock wild, particularly as the market makers will have read the same article. They will of course immediately ramp up their stock pre-trade both to ensure maximising a profit but also to try and regulate the order flow, reducing/discouraging the volume of buyers and encouraging existing holders to sell. After all a key part of their authorisation is to help ensure orderly markets.
Without such steps from a market maker, or when overwhelming hysteria takes over a market, like in 1999/2000, prices can move exponentially on tips and rumours as there simply isn’t sufficient stock available (liquidity) to satisfy demand. The flip side naturally is that when selling pressure begins and nobody believes in the magic anymore (so in most cases they’ve done very basic analysis) and hence there are no buyers prices can fall just as far, just as fast, without respite. Put simply market liquidity is the lifeblood of ordered price discovery, without it things can get a little tricky.
However in today’s markets where private investors play less and less of a role and most assets are traded in large (often leveraged) volumes electronically, the basic principles of liquidity appear to be lost on a generation – including professional investors. Frankly this alarms (actually: scares-the-bejesus-out-of) this wizened former Head of Desk, who has “been the market” on a number of smaller companies in the past, when orders were placed to move millions in shares that traded in just thousands daily.
Regrettably we see little commentary from the press or frankly other professional investors that indicate they really know how markets actually work (Spoiler alert: they really, really aren’t slightly rational much of the time, just in case you are a misguided Efficient Market Hypotheses enthusiast), let alone what happens when things are a little off-piste.
But modern market enthusiasts will point out how much volume (and they assume liquidity, which it isn’t as it doesn’t have to be there and can disappear, literally, in micro-seconds) has picked up in markets, driven in large part by High Frequency Traders (HFTs) and the Derivatives market, which in the case of the US has seen quotes rise from a staggering 50m per day in 2003 to a rather frightening 18bn quotes a day in 2015 (while digesting this you should also note these markets are very mathematically driven…this isn’t necessarily the same as rationally driven!)
However the problem is that there is no longer anybody who HAS to be in the middle (the LSE’s Jobber/Market Maker, or the NYSE’s Specialist are largely redundant) to guarantee prices/maintain orderly markets except in all but the smallest of equities, with everything else being traded on an electronic order book. What this means is that if prices fall quickly and electronic orders are taken out there can rapidly be no buyer to provide a market sell price and things can get very interesting very quickly.
This happened in 2010 when the US equity market “Flash Crashed” and lost 9% in around half an hour before recovering, all for no real reason. It happened again in the US Treasury market in 2014, when US Government Bonds, the safest of the safe (allegedly) witnessed a fall in yield of around 15%, again in the space of minutes and again for no real – rational – reason.
To put this into perspective the US Equity flash crash had liquidity disappear in the largest market in a global pool that trades approx $191bn of shares a day, while the US Treasury Market crash was in the largest pool in a market that trades up to $700bn a day…..and now Foreign Exchange….curious about the size of that market?
Yep: It’s Big! Well actually huge. In fact over $5.3tn……..yes TRILLION…daily. So one of the largest (but not largest) currency pairs in a market that big had a flash crash as liquidity disappeared.
If you aren’t VERY worried by that you really don’t get it.
Yes, it was overnight for London and New York so a thin time of day for Cable, relatively, however this shouldn’t happen, not outside one of the states suffering a nuclear attack or super-volcano. Outside of epic catastrophe there should always be some relative value in both sides of the trade.
The truth is, as we have covered before, markets are clearly and now publicly being manipulated by governments across the world as QE goes totally out of control, while the increasingly electronic underpinnings are themselves likely to breed instability in extreme situations. With the corrosive equilibrium having dissolved at the end 2014 and early 2015 (heralding the pick- up in volatility) we now see the G20 Currency Accord, which was key to stabilising markets in February, coming completely undone, without comment and, so far, effect (we will cover this crucial unfolding event in another post shortly).
Frankly everything now defies rational analysis and the omens for markets going forward has now become simply frightening, which is an opportune moment for PIMCO founder and Bond guru Mohammed El-Erian to step up and state in the FT:
“Like frogs swimming in a warm pot that is only slowly heating up to a boil, investors are generally calm for now, comforted by a distorted cognitive appreciation of their changing environment.
Blind spots and unconscious biases have been reinforced by the repeated prior episodes of effective central bank intervention that represses financial volatility. But if — or, rather, when — the water starts to boil, many investors would find it hard to jump out. Patchy liquidity and gapping prices would increase the cost and complexity of portfolio realignments.”
It’s not often we agree with an establishment figure but El-Erian isn’t the norm.
Returning to Sterling’s Flash Crash the BREXIT issue is clearly the background narrative for this event and some of the spectacularly ill-judged thoughts coming from the Tory party at their recent conference (or spectacularly well judged, in a very deeply Machiavellian BREMAIN way if the intention is to push soft-leavers towards remain and pull the EU towards greater flexibility as Sarkozy suggested at the weekend) haven’t helped sentiment, while Francois Hollande’s comments about effectively punishing the UK also didn’t help; but frankly to focus on these issues totally misses the point.
You see so much remains unknowable and however fraught the sentiment we now know there is at least 29+ months before the end of the two year Article 50 negotiations timetable, remembering also that a key clause of Article 50 is that it takes two years “unless the European Council, in agreement with the Member State concerned, unanimously decides to extend this period.” Frankly, despite the more serious panickers thinking “Everyone hates us, they’ll never all agree to extend”, I would beg to differ. The truth is that unless something changes dramatically then by then the world will be mired in the biggest economic crisis for generation and frankly being petty with your closest allies will look very silly.
No. There is no way the febrile and often irrational BREXIT sentiment of the City caused the Flash Crash, particularly when external observers see the UK continue to churn out among the strongest economic numbers in the developed world in direct contrast to all the pessimists’ predictions. Now we know they all say “Oh but it won’t last”, and it might not, but as they’ve been wrong so far why should anyone listen?
Sterling’s Flash Crash is a warning, but it really, really isn’t a BREXIT omen…..it’s potentially something much, much, much worse.