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Sterling's decline provides a lesson in currency movements
Why has the pound fallen so steeply against the euro? Jason Gaywood, director at currency broker HiFX, looks through the 'hocus pocus'.
The currency market is a fickle beast. Perhaps the most fickle of all financial markets. Often benign and seemingly dormant, she can explode into life with extreme volatility without any obvious warning.
Take sterling (GBP) against the euro for example. Throughout the last nine months of 2012, despite endless tales of Spain, Greece and others going bankrupt resulting in complete EU disintegration, the relative value of the pound against the single currency fluctuated by little more than 5% with sterling initially strengthening from around 1.2200 to just below 1.2900 at its peak in July before gently drifting lower again to close the year back in the low 1.2200s.
This dearth of volatility against the backdrop of huge uncertainty in the eurozone with hindsight seems remarkable. It is in direct contrast to how the market reacted to the prospect of a 'triple dip' recession in the UK that filled the headlines during the first weeks of 2013.
Indeed, GBP dropped like a falling piano during January – plummeting in a straight line from 1.2400 on the first day of the year to below 1.1500 (87 pence) a month later. The 7.5% swing this represents meant that there was more volatility during January 2013 than there was during the whole of the previous year.
This phenomenon seems perplexing and difficult to explain. Despite the prospect of our domestic economy slipping back into recession being entirely undesirable and depressing to most readers, logic would suggest that this news should be markedly less significant to traders than the seemingly very real possibility of European devolution we witnessed previously. Indeed, one could argue a pretty robust case that the structural problems faced by Europe are far from solved and that the ultimate break up of member states remains very much on the cards meaning that the euro is massively overvalued at this level. That, however, is another discussion.
How FX is different
So, why does the FX market seem to either over or under react to economic data or headline grabbing geo-political news? In order to answer this, one first has to highlight two key differences between this and most other financial markets.
Firstly, unlike equities or commodities, the value or price is not derived by the perceived underlying value of a stock or 'thing'. FX trading is concerned purely with the relative value of one currency over another or an attritional ratio of strengths if you like.
Secondly, and most importantly, approximately 97% of the $4 trillion that is traded daily in this most liquid of markets is based purely on speculation with armies of proprietary traders in both dealing rooms and front rooms around the globe placing short-term 'bets' as to which currency will strengthen against another.
These unique features often demote real world factors or 'fundamentals' such as GDP data or election results below the study of ‘technicals’ in terms of relevance to how the foreign exchange market moves.
This goes some way to explaining why we have seen such a dramatic fall in the value of sterling recently.
At the very start of the year, GBP/EUR was, coincidentally, sitting just above 1.2200. This was not unusual as it had done so on at least four occasions in the previous eight months. On each prior occasion, speculative traders around the globe collectively decided (for whatever reason) that at this level, sterling was undervalued and the euro was overvalued. Consequently therefore, each time the market dipped to this level they sold the overvalued currency in favour of the undervalued one which had the self-fulfilling effect of strengthening the pound and weakening the euro. In FX jargon, this level is called 'support'.
At the other end of the range – where sterling is considered overvalued against the euro – we have 'resistance'. Under normal market conditions, the currency pair will simply oscillate between these two key levels. This is why we often see a zig-zag pattern in currency charts.
However, at the beginning of 2013 we witnessed some mildly negative news regarding UK Plc and as such, traders were reluctant to purchase our currency for fear it wouldn't appreciate in value as it had done so previously. Instead, they either stayed sidelined or doubled their bets in favour of the euro. As GBP/EUR breached the previously solid floor (or support) at 1.2200, more and more speculators sold sterling against the euro leading to a rapid and self-fulfilling sell off down to the next support level at around 1.1500 which dates back to the previous low in October 2011.
As yet, this level remains unbreached with traders buying the pound from here leading to a rally to 1.1800. However, at the time of writing, we are re-testing 1.1500 and a clear penetration of this will open up a swift move towards 1.1000 (91 pence).
No hocus pocus here
This all might sound like a load of hocus pocus but if one examines any currency chart (as technical analysts do all the time), it is clear to see that these pivotal turning points do exist and are respected by learned market participants.
Whilst no-one can pretend to be able to accurately forecast the future, a simple awareness of technical levels in the currency market (rather than necessarily a full understanding of why they exist) can give all participants – whether they be speculators, risk managers, importers, exporters or overseas property owners – the ability to make informed and objective decisions about when to trade as opposed to basing their thinking on ill-informed emotion and sensationalist press articles alone.
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