Macro Commentary
Liquidity, liquidity everywhere except for the foreign exchange market in Asian trading hours overnight. That might seem like an obscure statement, but it has market moving consequences when combined with computer-driven trading programs. At least, the combination of low liquidity and computer-trading is the reason reported for why the the British pound (GBP) fell 6% overnight and only partially recovered the loss once the larger currency market opened in London this morning. As a G-3 currency, the British pound is a major store of value (one of the three purposes of money along with being a medium of exchange and a unit of account) used by central banks, institutions, and individuals around the world. It’s one thing to see that kind of volatility when a known event occurs like Brexit, but it is another when the news flow is light. It seems a bit of a stretch to attribute the drop to comments by French President Francois Hollande that Europe must be tough in trade negotiations at a dinner like some news articles have done.
To us, the event says a couple of things about market structure as well as GBP. First, computer-based trading continues to dominate day-to-day market trading not only in equities but in other markets such as currencies and derivatives. This means that trading volume statistics do not give a fair sense of “liquidity” (i.e. the ease of buying/selling a security at an observed price without affecting the price) since the volume could just as easily dry up if the computer program says to stop. They have no obligation to make an orderly trade book like the human market makers of old. Second, sometimes computers have glitches…or at least appear to have glitches. Since programmers are constantly trying to evolve their algorithms to account for new and innovative information to maintain a trading edge over competitors, eventually something may go a bit awry. Third, the technical chart on GBP (relative to USD) is terrible and every computer program (and trader) knows it. The foreign exchange market tends to be a highly technical market (traders look to patterns in price and volume for information) so without a pattern that shows clear support it is hard to attract a buyer. Fourth, and lastly, even if the overnight drop was a trading aberration it still damages confidence in the GBP. While the pound bounced off the reported lows, it did not fully recover leaving a lasting impact and concern of if or when it may happen again.