Backs To The WALL

Roger Williams reports on the sterling’s fall and recessionary fears ahead of the Brexit deadline

© Flickr: Alex Proimos

London and Wall Street stocks tumble as bond yields shout recession: The UK equities market fell 1.42 per cent on 14 August and dropped again later that day, Wall Street closed down 3.05 per cent.

The old motto of ‘sell in May and go away’, has been voiced more than once in August, not just in London and New York but certainly in Hong Kong where the nine largest property stocks were down by £47 billion.

In the Daily Telegraph only four days earlier: ‘Recession fears mount as economy contracts’, was the headline as UK Government statistics were released, revealing a 0.2 per cent contraction in GDP from the first quarter’s 0.5 per cent growth.

While it is well known that these preliminary figures are often revised months later and a contraction can be revealed to be an expansion, markets, hungry for data, will react. Days later, investors sold shares and bought bonds, rushing to safety.

Their bond buying on both sides of the Atlantic indicated they feared tougher times ahead as they tried to grasp the safety of government interest. The Treasury bond yield reversed, a classic signal of a coming recession within 18-24 months.

At the announcement of the fall in UK GDP, in the foreign exchange market (‘forex’) the pound hit its lowest value since 2009, $1.20 to the pound. Within days however, the exchange rate recovered to its pre-announcement level, as traders realised that the US was unlikely to increase interest rates with a recession ‘predicted’ by the yield curve.

Additionally, they realised other countries were in the same boat as the UK and others were contributing to global slowdown, specifically:

• Slowdown, if not recession, throughout Europe and the US, i.e. we are in the same boat as these countries;

• Failure of China’s resurgence in industrial production4 i.e. we are travelling in the same direction;

• Unstoppable move towards electric vehicles and the structural changes thereby required in car production (in location of car plants, components and manufacturing systems) i.e. the same problem for all car producing countries;

• Trade war between USA-China which impacts every country in the world and;

• Disruption of economies such as Hong Kong and economic-political problems of Argentina, Brazil, Venezuela, Iran and Turkey and Italy.

However, despite the complexity of global trade, it is important to understand the forex market because international trade in most sporting goods is priced in US dollars.

At $1.9 quadrillion, the forex market is the biggest market in the world, and the majority of the market is in London where 60 per cent of all forex trade is conducted.

The sheer size of the forex market dwarfs all other markets; it is 2.5 times World Gross Domestic Product; it trades twice the GDP of the UK in a day and 90 per cent of all trades are in US dollars. After the Euro and the Yen, the pound-dollar currency pair, has largest trade volume.

To think that the UK’s preliminary GDP statistics are the sole reason for the forex rate of the pound against the dollar is naïve. It takes huge trade to move such a big market. Like any market it is the balance of buyers and sellers that in the end determine market prices.

Traders’ expectations impact this but key to their positions in the forward market are the interest rates in the relevant currencies. Indeed, there is an automatic feedback between interest rates and forward rates through covered interest arbitrage which is ‘perfected’ as 90 per cent of forex traders use robotic trading.

At the time of the announcement of the UK’s GDP contraction, traders’ expectations of changes in interest rates in the US were upward and outweighed the expectation of a higher interest rate in the UK and resulted in a stronger dollar.

The tumble in the equities market four days later and purchases of government bonds on both sides of the Atlantic, led to higher prices for US and UK bonds and thereby lower interest yields (interest/bond price).

When the referendum was announced in the UK, forex traders’ expectation was that ‘remain’ would win the argument and the pound had an upward spike on the run up to announcement. The ‘wrong’ result caused a sharp drop (5 per cent) in the dollar value of the pound, as traders anticipated that lower UK interest rates would follow.

Today, traders are taking positions in advance of 31 October but this time, it is an even more uncertain situation. According to some, US interest rates need to go up (positive for a higher dollar exchange rate) to contain inflation but according to others, need to come down (negative for US exchange rate) as US growth falters.

This later opinion is winning currently as the reverse yield curve shows. According to many economists, UK interest rates will probably fall if the UK leaves the EU (lower pound to US dollar exchange rate) but according to others, interest rates will need to rise to combat inflation which hit 2.1 per cent last month according to government statistics (2.8 per cent if you follow the Retail Price Index).

If many traders have already taken a position expecting the UK to leave the EU and then we do leave, the pound may rise against the dollar on the announcement, as traders close out their ‘profitable’ positions.

If you follow exchange rates, or indeed the stock market, when a country or company, does something that people expect to happen, then you may get a movement in the exchange rate or share price which goes against your expectations. This is because people trade on their expectations in order to make a profit and impact of those trades can be seen before the event. 

From what we have seen in the weakness of the pound, it seems that there is an expectation that if we leave without a deal on 31 October; UK interest rates will fall. Some say the pound will hit parity to the US dollar if we do leave without a deal.

This may happen in the months or years after Brexit but you could lose your shirt trying to place a bet on it happening on Brexit day or the day after. Leaving without a deal may be priced into the exchange rate before 31 October.

If you are buying or selling in US dollars, consider covering the exchange rate if the deal is profitable at the rate when you make the trade. Prepare your plans for a recessionary environment, not just in the UK but on a grander scale encompassing Europe and the USA.

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