Since the introduction of the euro and the accompanying demise of the
tradable currencies it replaced, sterling has become increasingly
attractive. Andy Webb looks at the long-term trends.
Whatever view is taken of the merits (or otherwise) of the UK’s
membership of the eurozone, sterling’s continued existence has proved
something of a boon for many FX traders.
The arrival of the euro brought the demise of important tradables, such
as the deutschmark, franc and lira, creating a problem for traders who
were seeking diversification or simply something with which to make
their P&L targets.
Though many previously illiquid east European exotic currencies have
taken up a fair proportion of this slack, sterling has also proved an
increasingly important alternative tradable – and an attractive
tradable at that. FX markets seem unconvinced that the UK will be
joining the euro in the near future. Political ramifications aside,
current economic studies (such as Ernst & Young’s survey on
external investment into Europe) also appear to support this view.
However, UK Chancellor Gordon Brown’s recent statement regarding the
five economic tests for entry, plus uncertainties about the possibility
of a referendum, have resulted in a steady rise in sterling volatility
in recent months. Couple this with an increasing propensity for
trending and (with the exception of the breadth and volatility of its
bid-offer spreads) sterling holds out considerable promise as a trading
vehicle.
Long-term trends
Whether or not it is accepted that the importance of its survival
role alongside the euro is reflected in sterling’s behaviour, there can
be little denying that this behaviour has changed significantly since
the euro’s introduction on January 1, 1999. For example, in the two
years prior to the launch of the euro, GBP-USD largely traded to and
fro in the 1.5800 to 1.7000 range. However, in the two years following,
there were appreciably stronger trends both in terms of the major
downward trend during that period and in its reversals. The overall
trading range also expanded significantly: 1.4000 to 1.6750.
This increase in trending behaviour also persisted during the
subsequent two years (January 1, 2001 to January 1, 2003) with much of
the preceding downward trend being reversed in the process (see graph
1).
Graph 1: Sterling trend behaviour
While increasing flows into sterling after the launch of the euro may
account for much of this change in nature, there have been a number of
other influential factors. First, during the past 15 months there has
been a fundamental decline in confidence in the US economy, which has
driven much of the dollar movement in the same period. As a result,
some argue that it has been more a case of the dollar weakening than
currencies such as sterling strengthening that has driven the strong
upward trend seen in cable (sterling-dollar pair) since March of last
year.
Another factor has been the change in many banks’ risk appetites. In
the past, if a trader at one bank decided to take a major view on a
currency, counterparts elsewhere might decide to block the way by
taking opposing positions. Tighter risk management controls and loss
limits have made such behaviour far less common, so there is now a
decreasing likelihood of this sort of substantive obstruction to trend
development.
In part, this increasingly conservative approach to risk can be
attributed to the losses that many banks sustained in connection with
declining equity markets. In addition, the geopolitical situation since
9/11 has been extremely unstable, prompting a further reduction in risk
appetite. A further issue specific to FX is that, since the
introduction of the euro, many FX desks have been radically trimmed,
leaving fewer personnel to manage the book and resulting in a
reluctance to take substantive risks when thinly staffed.
This change in risk attitude is apparent in more than just spot
trading. In the past, in less liquid currencies, such as sterling,
option traders not uncommonly tried to defend their positions in the
cash market. For example, traders who had sold knock-in barrier options
would try to protect that barrier level in the spot market to prevent
the option from being triggered, while other traders would try to force
the market through the barrier level.
With the greater risk aversion prevalent today, traders are more
reluctant to defend or attack barrier levels because the risk/reward
ratio of such a strategy is not regarded as attractive. The net result
has been the removal of yet another barrier to development.
Bank economists also have an influence – or lack of influence.
Divergence of opinion among economists (and the degree of respect
afforded those opinions) used to encourage equally divergent opinion
among traders, making the evolution of trending less likely. Today,
processes such as interest rate decision-making have become
increasingly transparent and predictable so this divergence of opinion
is now minimal, thus removing yet another obstacle to trending.
Jekyll and Hyde
Although sterling may now be exhibiting trending behaviour on a
longer-term basis, its intra-day demeanour is different. Lengthy
periods of sideways inactivity are punctuated by occasional violent
break-outs, which are in turn followed by further inactivity (see graph
2). To some extent, this type of market behaviour is self-fulfilling:
traders see little reason to take a view in a flat market, as they may
not be able to recoup their losses in the same session if that view is
proved wrong.
As a result, sterling has a tendency to reach a level and hover there
while awaiting the arrival of the next major flow or news item. When it
arrives, it is typically seen as perhaps the only P&L opportunity
of the day, so proprietary traders consequently rush to participate in
the move before it ends.
This goes hand-in-hand with the shift in traders’ time horizons. Five
years ago, many traders felt comfortable with taking a one-month or
longer view of a sterling position. Now, that sort of approach is the
exception rather than the norm. In the current environment, more time
spent in the market is regarded as synonymous with increased risk, so
the preference is to get in and get out as quickly as possible,
preferably intra-day.
Although this is also true of other currencies, the tendency is
particularly pronounced in the case of sterling because the bulk of the
day’s activity takes place in London. Therefore, unless an exceptional
event takes place, there is little perceived benefit to running on
positions opened in London into New York or Far Eastern trading hours.
Furthermore, if a position is held over into non-London hours and has
to be cut, liquidity will be thin and a poor fill will probably result.
Graph 2: Sterling intra-day behaviour
Customer and technology influence
While risk aversion among proprietary traders has been a prominent
factor in sterling’s rather ‘stop go’ nature intra-day, a fundamental
shift in the behaviour of other participants has also reinforced this.
In the past, corporates or fund managers had a tendency to call up
multiple banks with the same (substantial) order. Cable or other
sterling pairs no longer have the liquidity to support this sort of
strategy, and even if it were attempted, the first tranche of the order
would alert other participants, who would mark the market away from it.
Particularly where there is a strong degree of trust between client and
bank, there has been a fundamental change in the way that sterling
orders are managed. In such circumstances, the client is prepared to
reveal the entire order to the preferred bank. As the bank then knows
that it does not have to scramble into the market to beat 10 other
banks with an identical order from the same client, it is able to work
the order gradually throughout the day, rather than suffering the
market impact of a single large trade. This has a considerable
influence on sideways periods of market behaviour because the bank has
the freedom to feed the order in gradually, letting the market fall
back (for a buy order) to the bottom of the trading range before
executing the next tranche.
The switch from voice to electronic trading has had a similar
influence. Because electronic trading is anonymous, traders are less
reticent about entering multiple small orders during the course of a
day, whereas in the past they would have been embarrassed to make
frequent approaches to voice brokers in small size (the response from
the voice brokers to such an approach would also have been less than
co-operative). And the anonymity of electronic trading has made traders
far less concerned about reversing or cutting positions with tight stop
losses, further fuelling the narrow range intra-day fluctuations that
are often seen in sterling.
Who benefits?
Sterling’s increasing volatility and trendiness benefits a variety
of market participants – commodity trading advisers (CTAs) being an
obvious case in point. Historically, CTAs have favoured currencies
because of their greater propensity for trending, particularly when
compared with markets such as agricultural commodities, because this
behaviour fits well with the trend-following strategies that many of
them use.
Arbitrageurs have also been major beneficiaries of sterling’s change of
behaviour, as increasing volatility has thrown up numerous trading
opportunities. This is in stark contrast to the period immediately
before the euro was launched when many currencies (particularly those
due to be subsumed into the euro) were flat to the point of tedium.
Increasing arbitrage activity among EUR-GBP, EUR-USD and GBP-USD as a
result of greater sterling volatility has provided a wider benefit to
the market as a whole. If arbitrageurs see a large order offered
perhaps as much as five points off the market, they may still be happy
to take the price if it will allow them to lock in an arbitrage that
still offers adequate margin. This, in turn, encourages other
participants to continue showing prices in the market, thus supporting
liquidity.
However, despite the broader advantages of increasing arbitrage
activity, the sterling market is still a far-from-perfect arbitrage
vehicle due to the breadth and volatility of bid-offer spreads. A
market where the spread can fluctuate from two to six points and back
again in a matter of seconds is hardly an ideal backdrop for
arbitrageurs.
An alternative source of sterling liquidity would do much to improve
this because the overlapping bid-offer spreads that should inevitably
result would provide a tighter net dealing spread. These tighter
spreads would boost arbitrage activity, which would further enhance
overall liquidity – thereby also negating the traditional argument that
a parallel market begets liquidity fragmentation rather than
improvement.
What next?
As mentioned earlier, the eastern European exotic currencies have
absorbed much of the liquidity that formerly belonged to the first wave
of euro entrants. As such, it is tempting to assume that when these
exotics join the euro, sterling will be there to benefit from the
ensuing liquidity slack. Will sterling’s volatility and trendiness
thereby become even more pronounced?
The short (and obvious) answer is that nobody knows. But there are
reasons to believe that history could repeat itself and that another
group of exotic currencies could pick up the liquidity benefits instead
of sterling. Rather than trying to squeeze more liquidity into
sterling, many proprietary traders may prefer to switch their
activities to currencies such as the South African rand, Asian exotics
or the Middle Eastern currencies. For some second-tier banks that have
little leverage in the major currencies, there is also the attraction
of being able to develop a niche specialism in some of these currencies
and thereby generate some buy-side revenue on the back of this as
liquidity in these exotics increases.