Attempting to quantify the impact of sterling weakness

Another day, another trip to the hospital for Betty as sterling sold off sharply yet again.  While the so-called Flash Crash has certainly projected the pound into the public consciousness, ironically enough it trades as if medium term discretionary punters (if such a creature even exists any more) aren't really very short at all.   CTAs and models, sure: just look at the CFTC data.  But day to day price action certainly trades as if macro/FX guys are hoping for a decent rally to sell...and not getting it.

(Parenthetically, any global financial regulator disturbed by last week's sterling crash should take a good look in the mirror and consider the irony of karmic justice.  In the "bad old days" when bank spot and prop desks took risk on a principal basis, sudden dips resulting from a liquidity air pocket were swiftly bought by those traders, certainly well before anything like an 8 or 9 big figure sell-off.  By forcing banks to more or less act solely on an agency basis, regulators have put the market at the mercy of black box 'liquidity providers' which can also act as seek and destroy robots.   This type of price action is more or less inevitable in a large enough sample size; for better or for worse, regulators have gotten the market that they wanted.)

In any event, Macro Man has some sympathy for the view that sterling is cheap on a long term structural basis, though of course that says little about where it is going in the next day, week, or month.   For what it's worth, the OECD puts cable PPP at 1.44 these days and EUR/GBP at 0.90.   (That latter figure seems awfully high, as does the EUR PPP of 1.30.  Macro Man would peg the latter closer to 1.20, and EUR/GBP closer to 0.80.)

One subject that is becoming a frequent topic of discussion is the degree to which sterling's free fall will benefit the economy.   If maintained, of course it will help boost exports, though how much will naturally depend on the tariff umbrella under which the UK eventually trades.  (The boost to exports should come earlier, of course.)   Initially there could actually be a deterioration in the trade account via the well-known J curve effect, in which import prices go up but volumes remain steady.  Eventually, we can naturally expect imports to decline, improving the balance of trade...though potentially with a hit to household spending if volumes adjust downward in response to price.

Ordinarily, households would be cushioned by a more aggressive easing of monetary policy in response to an economic shock.  That's not really an option here, so it seems reasonable to expect less of a beneficent impact from a weaker sterling than has historically been the case.   One way that we can attempt to quantify this is via a monetary conditions index, which equates moves in the trade weighted exchange rate with changes in interest rates.    A useful rough and ready estimate is that a five percent move in the exchange rate is equivalent to a one percent change in interest rates.  (Note that the ECB MCI uses a 6-1 ratio.)  The chart below shows monetary conditions in the UK relative to the average between 1998 and 2007, which represented a full monetary policy cycle from an independent Bank of England.


As you can see, the downdraft in the sterling TWI has had a notable easing impact, though much less than observed in the early 90's after the ERM crisis or during the GFC.  As such, it's hard to see it being a panacea for any potential potholes that may emerge.   A potentially valid criticism of this model is that the UK is a pretty open economy, and as such should tilt its MCI weightings more heavily towards the exchange rate.  

UK trade as a percentage of GDP is comparable to that of Canada, another open economy perched on the doorstep of an economic behemoth, with whom it has a free trade agreement.  (For the time being at least in the case of the UK!)   The BOC managed policy to an MCI index for a while in the 1990's before junking it in favour of inflation targeting.   Their MCI was weighted 3 to 1, which may arguably be a more  apt fit for the UK.   The chart below illustrates a UK MCI with those weights:

As you can see, the current move still pales in comparison with prior sharp easings; both the early 90's and the GFC period saw conditions ease by 15% on this index basis.  Looking at this index in a little more granularity, we can see that as of yesterday the sterling MCI had done about half of that.


Of course, the starting points are not identical.   The early 90's saw a recession, property crash, and ERM currency crisis.   2008-09 was of course the financial crisis and concomitant bone-jarring recession.   What we have now is a constitution altering vote of uncertain ultimate consequences that has left roughly half the country happy, half the country sad, but everyone, judging by the tone of the discourse, very angry indeed.  We do not, on the other hand, have recession as a starting point.


It's perhaps best left to the econometricians to make hard and fast forecasts of the impact of the MCI move.  From Macro Man's perch, he can see a clear upward impulse to inflation via the import channel.  As for growth, to date it hasn't collapsed so there isn't much of an argument for a sharp upswing in response to the sterling weakness.  As noted above, next exports will certainly improve, though potentially at a cost to consumption data, leaving the boost to GDP growth somewhat muted.

Eventually, conditions should evolve such that there is a case for sterling appreciation.  It is far from clear that the level is here and the time is now, though obviously longer term investors may have the luxury of starting to peruse the family jewels goods on offer.  From a purely selfish perspective Macro Man would love to see cable back to it's 1980's lows...having endured years of cable at 2.00, he'd love to be able to walk around London marveling at how cheap everything is for once.
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checkmate
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October 12, 2016 at 7:29 AM ×

I think you made a reasonable fist of trying to be objective about the effects of currency on growth in the UK. In doing that you were primarily focussing on how it as worked in the past when in harness with monetary policy.
Personally, I think the usefulness of looking at growth this way ,at this time, will be less effective IF the UK changes tack and goes to fiscal policy as the primary driver. Let's face it enough central bankers have been shouting at goverments to do just that for quite sometime now. Perhaps now someone is actually listening?

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washedup
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October 12, 2016 at 11:22 AM ×

@MM - another big difference from the 90's is that the biggest implications of a weaker sterling are much more likely to be manifested through the asset channel, namely foreigners rushing to buy now 'cheaper' property, as well as Uk businesses and equities, and not increased business activity. the dismal science (!) is practically begging for a new theory that treats asset valuation and consumption/investments as working at cross purposes as far as monetary impacts go. The washed-up hypothesis stipulates that in a world with high leverage t the basic tenet of capitalism, i.e. the fiduciary responsibility of economic agents to capital providers, results in narrowly rational choices that favor return of capital, starve overall investment, and ultimately lower future productivity.
In short, the current conditions in the UK are more likely to result in stagflation rather than rapid growth.

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12yo HFM
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October 12, 2016 at 11:36 AM ×

While I wait for my Dax/DB 'hedge' to add some much needed alpha to my PnL, this Pettis article on inequality/debt/trade balances is worth a read:

http://www.handelszeitung.ch/blogs/free-lunch/we-clearly-want-political-redistribution-1221235

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October 12, 2016 at 11:36 AM ×

"But day to day price action certainly trades as if macro/FX guys are hoping for a decent rally to sell...and not getting it."

Macro Man - as somebody much less experienced in markets than you, might you be able to give a more spelled out explanation of what you can see in the price action that suggests to you that macro / fx guys are looking for a rally to sell and not getting it? As opposed to CTA's etc...when you are looking at the charts / tape, what do you look for that gives this away? do the big gaps reveal to you machines ? What are the tell tale signs?

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Anonymous
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October 12, 2016 at 12:04 PM ×

Mr Wong - Have you given up betting on racing and moved to trading financial markets?

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washedup
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October 12, 2016 at 12:13 PM ×

@12 yo - that article was a very good read - superstring macro!
I do find it comical that people still talk about the need for 'political solutions' as if its an abstraction - take a look around at the people who run the world and tell me which one of these clowns inspires confidence in pushing a major overhaul without the threat of a major crisis first. That is precisely why I am skeptical of the 'fiscal stimulus' idea - just because its the right solution doesn't mean it will happen without a catalyst. Wily Larry (Summers) is setting the stage for his appointment to the Clinton cabinet because he knows there will be a lot more talk about it in coming quarters.

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October 12, 2016 at 12:42 PM ×

Brexit the new risk to focus on, in addition to higher yields.

BREXIT is currently a net negative to the financial markets, whereas in June, it was a net positive, as the overwhelmingly positive ancillary benefit of lower global bond yields outweighed the eventual headache of the eventual exit process. Now as yields relentlessly move higher, and exit looming (within the market's horizon attention span), BREXIT is just a big risk.

http://crackerjackfinance.com/2016/10/pounded-brexit-risks-hit-markets/

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Anonymous
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October 12, 2016 at 1:31 PM ×

washed: thats the problem of living in a democracy these days (que Winston churchill's US quote, but its really all developed market at this point), those rocking the boat pay the price, but get none of the rewards (the guy after you gets the acclaim after you get tossed over the side of the boat).

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12yo HFM
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October 12, 2016 at 2:01 PM ×

Midday Fund Update:

Our attempts to 'hedge' losses in US equity positions by buying EU equities met with limited success yesterday. This morning I met with our fund's risk manager who summed up our net position in the following immortal words, "Dude, I can't even...". Quite.

However all is not lost; by reporting our fund's PnL in sterling, we have turned an unpleasant DD into a healthy YTD profit ;)

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Punta
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October 12, 2016 at 2:12 PM ×

12yo you crack me up - this and yesterdays pnl support comment is classic

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WidowMaker
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October 12, 2016 at 5:39 PM ×

Does anyone else feel like the yen is being bid as a risk aversion measure, however following the fed minutes today it will be sold?

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Anonymous
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October 12, 2016 at 5:41 PM ×

I would wager that is what most are thinking. However, what if minutes are really hawkish and it keeps going?

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hipper
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October 12, 2016 at 6:45 PM ×

What's peoples view if UK goes on the path of this "fiscal stimulus" which CBs all around have been screaming for what feels like an eon already? Will it be the pioneer going into the dark with others following and will this cause a general global rise in rates? It's just gut feeling but in the event of fiscal stimulus controlled by governments would at best cause some temporary impulse to growth since they never "invest" productively in the long term, but what happens in the short term following such announcements would be interesting. Similarly, excluding the fiscal stimulus, even if "only" UK import costs rise and cause a rapid inflation spike causing UK rates to go up as well, is it possible that it would be a contagious event in the West or only a localized event. But yeah if almost every asset class valuation is currently driven mainly by the low rate narrative I just figured it might be a relevant question.

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12yo HFM
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October 12, 2016 at 7:26 PM ×

Having a nap during the "Fomc lull", I need to get rested for the Sydney FX open, when GBP/USD will undoubtedly move 300-600 pips...

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Anonymous
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October 12, 2016 at 7:44 PM ×

Guys, I am from a sports betting background so bear with me if this seems a bit basic...

Am evaluating opening the following trade:

Short gilts at around 127.20...

stop loss at, say, 132.50 if it takes out historic highs...(staked to lose 10k in this scenario)

take 50% profit it market hits below 107.50...ie testing 2014 lows...let rest ride and move up stops...

geared sort of 4/1...

basing levels on this chart, which I assume is a continuous front contract chart?

http://uk.investing.com/rates-bonds/uk-gilt-streaming-chart

Couple of questions: Is this a crazy bet? looking obviously for market to apeshit against UK government and for them to get trapped with tumbling currency and loosening purse strings...maybe helped by worldwide reflation trade and gloval sov selloff with gilts to lead the pack...

Would you guys ever consider a trade of this type with such wide stops? Rarely see this sort of Rio trade mentioned here - is that because it's crazy?

What would be the funding cost of rolling/carrying a position like this for a year? Would it be enormous and make the bet non viable? Are there option prices from which I could derive a implied indication of the % chance of one of these stops being hit within a 12 month time horizon? If so, how can I access this data without a bloomberg terminal?

Is somebody trying this sort of strategy likely to go skint fast?

Be lucky, Harry.

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12yo HFM
admin
October 12, 2016 at 8:06 PM ×

Is this a crazy bet?
Only if it loses. Otherwise, it's pure genius.

Would you guys ever consider a trade of this type with such wide stops?
Stops? Hahahaha....

I'll leave the technical questions to my elders & betters. Peace out.



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Mr. T
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October 12, 2016 at 10:24 PM ×

Harry, just consider the FX - heres front month gilts in GBP vs USD...

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Skr
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October 12, 2016 at 10:29 PM ×

@12yo HFM 7:26
Are you looking at the divergence on the FTSE to preempt sterling move and... Oh, nevermind - that be too easy.

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