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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'.

 
Sterling's decline provides a lesson in currency movements

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.

Remarkable calm

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.

Real world?

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.

10 comments so far. Why not have your say?

Micawber

Feb 18, 2013 at 08:51

You don't suppose events leading to Cameron's January announcement that the UK will have a referendum on leaving Europe has anything to do with it, then?

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John Osborne

Feb 18, 2013 at 11:13

. . . and possibly a realisation that the government has neither done enough to cut UK deficits, debt, or rebalance our economy, unfortunately. Only print money,mostly wasted.

As a result, whatever the short term traders say and despite the recession, we are still running a huge balance of payments deficit , which can only be negative for sterling.

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William Bishop

Feb 18, 2013 at 16:42

The euro has been gaining credibility (although this could easily reverse, for instance, if Berlusconi did unexpectedly well in next week's election), and sterling losing it (because the benefits of fiscal austerity are not -yet?- apparent).

A 7 1/2% move is not that big a deal, particularly when it is into a range where quite a lot of time was spent post-2008, although it may have seemed volatile compared to 2012.

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Keith Snell

Feb 18, 2013 at 19:33

The pound dropping in value will clearly help our exporters on whom the entire country depends, markets anticipating this is inevitable, however to those of us who invest it is just another factor to consider, like many people I have taken profit from the recent upwards trend and will reinvest if and when I see a worthwhile opportunity. Factors such as EU referenda are currently entirely irrelevant. At this stage they are for politicians and other producers of industrial quantities of hot air.

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W D Morris

Feb 18, 2013 at 19:50

"97% of the $4 trillion that is traded daily in this most liquid of markets is based purely on speculation "

But this is zero sum game, for every winner there is an equivalent loser. So how do banks worldwide continue to play, since they cannot be stupid.

Is it just the problem gamblers conceit - that he will always be the winner not the loser?

Or is it that they can gamble with shareholders money, backed by governments and taxpayers if thing go wrong, meanwhile taking a huge bonus cut for themselves if they hit a winning run?

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Long Term Investor

Feb 18, 2013 at 20:18

In answer to WD Morris - the answer is 'Yes'. Read 'Fooled by Randomness: The Hidden Role of Chance in Life and in the Markets' by Nassim Nicholas Taleb. There are so many gamblers out there that some of them are sure to make spectacular gains for a while, which gives them thew accolade of being a 'Star Trader' and the mega bonus to go with it.

Unfortuantely this impacts on our everyday life. Thats why I would not dare trade currency, but am happy to back well capitalised, successful equity businesses, which the gamblers can affect for a while but not for ever.

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Jon

Feb 18, 2013 at 21:01

This is a sort of correction. Since our balance of payments has been running a big deficit for the last 20 years, and the whole pf the GDP rise in the Brown years was a false boom based on expanding credit, then the GDP has to fall back to where it should have been. The fact that it has not can be accounted for in the long term by a devaluation of sterling. So, from a global viewpoint our GDP in,say , $, has fallen.

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mark antrobus

Feb 18, 2013 at 23:59

Given that the UK's growth prospects have taken yet another turn for the worse, it is entirely rational that the £ should fall, as the start of any Base Rate increase moves further into the future. Although imported prices will increase, such a fall in the £ is actually good news as it will help the UK to achieve an export - led recovery - delivering growth, jobs, a closing of the trade deficit, and even growth in tax revenues. No doubt all these benefits will not suit everyone, as will be evidenced by the complaints about a lower £.

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Anonymous 1 needed this 'off the record'

Feb 20, 2013 at 07:53

The pound has to be depreciated, how else are we going to make a unproductive, overpaid and poorly skilled economy competitive with the rest of the world, certainly not by increasing the consumption of the average person in the UK.

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John Osborne

Feb 20, 2013 at 10:10

Anon1

Unfortunately I have to agree, but with the proviso that it is not a means in itself.

Our governments over the last 16 years should have been doing far more to boost infrastructure export industries and related education.

Britain is virtually bankrupt, throttled by high taxation, woeful transport systems, wasted public expenditure and poor expensive education.

Until all these areas are tackled we will see continuing devaluation and decline.

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