In the aftermath of the surprise Brexit decision, many investors found themselves on the wrong side of the trade. After all, it was widely believed that although the vote would be close, there was no way the British people would choose to self inflict all the economic pain that a separation from the EU would entail.
As the vote results trickled in, and the brutal reality set in that the average British voter was fed up with Brussels, the markets descended into a panic, extrapolating all sorts of overly dramatic outcomes. There was talk of a repeat of the 2008 credit crisis, or how Brexit would trigger the same sort of economic disaster as the Greek debacle.
I argued Brexit would not be a big deal. During the Greek panic and the 2008 credit crisis, there were threatened defaults that would likely cascade through the global financial system. Brexit had no such worries. Britain did not share a currency. There was no entity threatening not to pay.
Brexit was nothing more than the rejection of an extremely elaborate free trade agreement. Yeah, yeah, I know - that’s an overly simple description, but there can be no denying that initially, the market completely misjudged the consequences.
The decision by the Bank of England to subsequently flood the British economy with liquidity has obviously helped. And to be fair, Britain has not yet formally requested to leave the EU, so there might still be some longer term consequences to be felt. But on the whole, Brexit was way more of a “non-event” than most investors predicted.
Yet there is one British asset class that is still reeling from the outcome. The ongoing worry from international investors regarding the UK’s place in the global financial system, and all the BOE liquidity that Carney has flushed into the economy has taken its toll on the pound.
After an initial drop from 1.50 to 1.35, the pound has spent the last few months treading water between 1.28 and 1.35. There has been virtually no rebound from the Brexit damage.
And in case you think this is just a US dollar story, the chart against the Euro looks the same.
As usual, where there is even the smallest bit of a trend, hedge funds and other speculators have pushed the trade to Tokyo-subway-crowded levels. The pound went down on the Brexit news, and barely bounced due to the BOE response. Of course this means that piling on the short side of the pound is the trade-du-jour.
Have a look at the chart of the net speculative positioning on the CME for both the pound, and for contrast, the Euro.
The net short position in British Pound is at all time highs! While speculators are also net short Euros, the position size is miles away from the all time high.
I understand why the pound might trade heavy versus the US dollar. The Federal Reserve hasn’t expanded its balance sheet in many moons and is even threatening to raise interest rates. The Bank of England is cutting its benchmark rates and aggressively engaging in quantitative easing. So yeah, some pound weakness against the US dollar is somewhat understandable.
But the pound is threatening to hit new lows against the Euro. It’s not as if the ECB isn’t also cutting rates and expanding their balance sheet. Yet here we are with the EURGBP cross rate bumping back up to the 0.86 level.
Europe is a complete shit show. Their biggest banks are imploding in front of our eyes. Their economy desperately needs a much lower currency. The political situation is drifting towards more anti-EU sentiment with Merkel’s party recently suffering the worst defeat since 1945.
Leaving the EU is probably the smartest thing Britain could do under the circumstances. After all, we know as traders, throwing good money after bad because you are offside is a cardinal sin.
I think that selling the EURGBP rate offers a compelling risk reward. I already had the position on in a small way from this summer, but I am standing in here at this level in a much bigger way.
I can’t figure out if I like the pound more than I hate the Euro, but I don’t think it matters. The hedgies are pushing their luck on this pound short. Their overly bearish view could bite them in the ass.
In this day and age of limited world growth, aggressive balance sheet expansion with an engineered mild currency devaluation is pretty well the only proven recipe for medium term economic growth. The US did it after 2008 and although you might argue about its long run efficacy, the policy created the world’s strongest (on a relative basis) economy over the past several years. I expect it will work equally well for Britain in the coming quarters.
Thanks for reading,