*Please note this article was written before the recent “flash crash” in the pound.
The pound has returned to the forefront of investors’ minds after PM May took the opportunity afforded by last week’s Conservative Party conference to announce the start-date for Brexit negotiations. Article 50 – the pertinent EU legislation – will be triggered by March next year paving the way for a repeal of the 1972 European Communities Act that took the UK into the EU.
The Multi-Decade Low
The news put the skids under the UK currency, sending it down to fresh multi-decade lows versus the dollar, amid concern that the two-year timetable for leaving the EU stipulated by Article 50 will not be sufficient time to agree on new bilateral trading arrangements (precedent suggests these negotiations take several, if not more, years). In other words, there is an increased risk that Brexit will be of the growth-damaging “hard”, as opposed to “soft”, variety.
By itself, the announcement hardly constitutes much in the way of a surprise. Once PM May had publicly acknowledged that “Brexit means Brexit” and given the pressure from the rest of the EU “to get on with it”, it was inevitable that it would occur at some point during 2017.
The reason why the announcement had a significant market impact is that it came at a time when extreme negativity towards UK economic prospects, as observed in the weeks following the Brexit vote, had been largely unwound as it can be quantifiably demonstrated via crowd-sourced UK economic growth sentiment indicator having risen back towards zero (see chart below).
By contrast, had the announcement been made in late July, when the crowd was very pessimistic about the UK economy, its market impact would have almost certainly been more muted; its effect diluted by all the other negative news floating around at the time.
Revisiting the crowd-sourced sentiment data utilised to flag the potential for a short squeeze in the pound in late July/early August, one might have expected that sentiment towards the UK currency would have fallen back as the subsequent pound rally reversed.
However, as the chart below confirms, this is not the case. Instead, just like economic growth, sentiment towards the UK currency has moved back to broadly neutral – a zero reading for the indicator means that it is in line with its long-run average.
This suggests that having observed a 10% plus pound devaluation since June 23rd – a currency move that is in line with the UK Treasury’s pre-vote analysis of the impact of Brexit – the crowd is largely agnostic about the future direction for the pound at this point in time, something not readily apparent from a cursory glance at some more dramatic news headlines this week.
As any experienced investor will confirm, there is a significant difference, mentally, between taking off an existing investment position, where an emotional attachment has been formed, and initiating a new position, where there is little emotional attachment.
It is this psychological aspect that makes pain trades so potent. A price move in the opposite direction to an existing investment generates mental anguish (as well as having negative P&L implications), and this provides a powerful driver for capitulation, especially when the view is widely shared amongst market participants.
Trades In The Coming Weeks
In late July/early August, pound shorts were a classic pain trade given the strong skew in crowd sentiment. But, as just noted, this is no longer the case. For the pound to move significantly in either direction, it will require the crowd form a new “mental” attitude towards the UK currency.
Just as it is possible that the latest drop in the pound constitutes an over-reaction to the announced start date for Brexit negotiations (implying the pound is ripe for another bounce), it is also possible that because sentiment towards the UK currency is no longer as bearish as it was previously there is considerable scope for crowd negativity to return, driving the exchange rate even lower.
How the pound trades over the coming weeks is entirely dependent upon how UK economic growth perceptions evolve. To the extent that growth worries return driven by fears over the detrimental impact of a “hard” Brexit, the pound will be under pressure to depreciate so as to provide an offsetting easing in monetary conditions (reinforced, no doubt, by additional BoE easing).
Unlike other sentiment analytic companies, Amareos provides a high degree of granularity in its sentiment indicators, meaning one can track specific individual emotions such as fear. Indeed, using the UK country and GBP Fear indicators to great effect during the campaign helped outline – in earlier articles – the effectiveness of Remain’s Project Fear strategy. As can be seen in the chart below, these Fear indicators also served as useful lead indicators on UK growth dynamics during the “Brexit period” – both anticipating the slump immediately after the vote and the subsequent rebound.
Even though crowd sentiment towards the UK currency is broadly neutral, with both Fear indicators on the rise once more, this tips the balance in favour of a continued bearish outlook for the pound. Indeed, this sentiment neutrality suggests the downside for the pound over the coming days and weeks is considerable as there is plenty of scope for renewed public fears over Brexit to fuel increased pessimism, as alluded to above.
Select Company – The Pound, The Rand And The Real
Finally, the pound is not the only currency which appears vulnerable to the downside. A quick scan across the sentiment data flagged two strong “pain trade” candidates. As the chart below illustrates, of all of the 32 currencies, the South African rand and the Brazilian real are the two with the most elevated sentiment readings (i.e., the strongest skew).
What’s more, both currencies have seen sentiment weaken over the past month (momentum turn), markedly so in the case of the South African currency amid worries that it may lose it investment grade status in December and increased domestic political noise. As one saw with the pound just a few months back, this combination can be a very useful signal that the prevailing price trend is about to reverse.