What the crashing pound means for your money

published 10 October 2016

161010-sterling-b — Markets worried about a "hard" Brexit sent sterling plunging

Last week was rather an exciting one for markets.

The prime minister gave us a deadline for Brexit. Upon hearing all the tough talk at the Conservative party conference, the pound took fright, and ran for the hills (or rather, the valleys).

So what's next for sterling, and what does it mean for your investments?

Subscribe to MoneyWeek

Subscribe to MoneyWeek today and get your first six magazine issues absolutely FREE

Get 6 issues free

https://cdn.mos.cms.futurecdn.net/flexiimages/mw70aro6gl1676370748.jpg

Sign up to Money Morning

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

What lies beneath the sterling flash crash

There's no explicit definition of a "flash crash", but it describes a situation where an asset slides (or soars) by a far greater amount than usual in a short space of time, for no obvious reason.

Often "fat finger" trades (where someone puts the decimal point in the wrong place) or computers ("algos", as they're called) going off into a frenzy of selling, get the blame.

So how did it happen this time? The Financial Times makes the point that the pound isn't the only currency this has happened to in recent years.

The New Zealand dollar (the kiwi) tanked against the US dollar during last August's China panic (remember that particular panic? It came just after the Chinese devalued the yuan). And the South African rand took just 15 minutes to slide by a whopping 9% against the dollar in January this year.

This is partly down to banking regulations. As the FT puts it: "Tough capital requirements are making it more expensive to hold customers' trades on their balance sheets". It's also down to the fact that lots of traders have left the business after the world somewhat understandably got upset and fed up with their constant manipulation of everything from Libor to foreign exchange rates.

You add this all up, and it makes the market less liquid. In other words, you can't guarantee that buyers will always find sellers, and vice versa. That makes it more likely that big moves in price will happen, particularly if all the trades are being executed by trading programs, rather than human beings.

Indeed, just a few days before the pound slid, Bank of America warned of this very thing. Because trading volumes are in decline, reports Bloomberg, "transactions have a 60% greater impact on prices than just two years ago".

Of course, none of this is helped by the fact that the pound is in no-man's land. From a technical analysis point of view, there's no "resistance" between here and the pound's 1985 low which was around $1.05.

I'm not a chartist, but put simply, it means that the pound would have hit a lot of price points at which people were keen to sell up (because of stop losses) and no obvious point at which they would have wanted to buy en masse.

You don't start a negotiation with "OK, you win"

(It's not all about the pound, by the way. The US dollar has also been strengthening as investors start to believe that the US Federal Reserve is serious about raising interest rates soon. That's why gold had a crummy week too.)

The concern for the pound started when Theresa May said last weekend that Britain would trigger Article 50 no later than next March. Britain wants to trade. But it also wants control of immigration.

The immediate assumption of most people is that this means Britain is out on its ear. The laws of physics of the EU state that you can't be a member of the Single Market and also opt out of freedom of movement. Therefore, there is no middle ground.

This, of course, is nonsense. The EU's rules are not like gravity. They're not even like the Ten Commandments. They are an agreement that can be altered. Britain is currently in the process of negotiating changes to that agreement.

And you don't start a negotiation by saying: "We want A, but we'll accept B. And if you bargain really hard, we'll go all the way down to C. What's that? You want C? Umm fair enough."

As May said in her speech: "History is littered with negotiations that failed when the interlocutors predicted the outcome in detail and in advance".

The EU is doing the same thing. You just need to look at the language being used on that side of the Channel to see that. Here's EU commission president Jean-Claude Juncker: "I hope entire chunks of European industry won't engage in secret discussions, in dark rooms, curtains drawn, with British government envoys". It almost makes negotiating over tariffs sound jolly good fun like something out of a Cold War novel.

Anyway, the overall impact is that the market got a follow-on fit of Brexit jitters. And with the pound being in a bit of a trading vacuum, and everyone keen to "short" it anyway, it tanked.

What it all means for investors

And even the UK market has done well. After all, nearly every country around the world wants a weak currency. Britain is one of the few that has so far achieved this.

Will it carry on? The tricky thing with all this is that there are so many moving parts. Bank of England boss Mark Carney might now be a bit more circumspect about weakening the pound any further. So maybe lower interest rates aren't on the cards any more.

The US election will have some sort of effect too. And you never know where a crisis will erupt in Europe next.

We're suddenly in an era where politics really matter. And that makes markets even harder to predict. The only solution is to diversify.

As Merryn Somerset Webb pointed out at the MoneyWeek Conference last week, "diversify" sounds like boring advice. It's not.

It doesn't mean "buy everything". It means that you need to make sure that the success of your portfolio doesn't hinge on one particular asset or investment scenario. I'll be talking about it more later this week, but it's probably the most important thing that you can do right now. Meanwhile, if you missed the conference, you can pick up your DVD copy here.

John Stepek is a senior reporter at Bloomberg News and a former editor of MoneyWeek magazine. He graduated from Strathclyde University with a degree in psychology in 1996 and has always been fascinated by the gap between the way the market works in theory and the way it works in practice, and by how our deep-rooted instincts work against our best interests as investors.

He started out in journalism by writing articles about the specific business challenges facing family firms. In 2003, he took a job on the finance desk of Teletext, where he spent two years covering the markets and breaking financial news.

His work has been published in Families in Business, Shares magazine, Spear's Magazine, The Sunday Times, and The Spectator among others. He has also appeared as an expert commentator on BBC Radio 4's Today programme, BBC Radio Scotland, Newsnight, Daily Politics and Bloomberg. His first book, on contrarian investing, The Sceptical Investor, was released in March 2019. You can follow John on Twitter at @john_stepek.