Yesterday the UK Prime Minister Theresa May gave a speech at Lancaster House which outlined potential objectives for the country’s Brexit negotiations. In it, she presented a Brexit plan that suggested a more meaningful break with the European Union than many of the possible options.
So why did Sterling strengthen versus the Dollar and Euro?
It runs contrary to many expectations. Price action and received wisdom have suggested that Sterling does not like signs that a “hard” Brexit will be enacted. As a result, much commentary has revealed confusion as to why Sterling went up just as we were presented with the clearest evidence yet of a hard Brexit.
“Ex post rationalisation” is common in financial markets. It refers to the action of creating an explanation for why something happened, after it has happened. In the case of yesterday’s moves a number of reasons have been put forward:
- The announcement that the final terms of the deal would be put to vote in Parliament could mean that the final Brexit might not be so “hard” after all
- The speech had been widely leaked over the weekend and so was not a surprise to markets, in fact its final form was ‘softer’ than anticipated
- Technical factors and investor positioning meant that having made money out of the short Sterling trade, the signs of some resistance earlier in the day prompted traders to close out these positions
One, all, or none of these forces may have been significant, but what they all reveal is an interesting case of “efficient markets” thinking which is pervasive in much financial market analysis.
“Efficient markets thinking” is the tendency to believe that markets can only move because ‘new information’ has come to light i.e. there must be a clear reason we can point to in order to explain market moves. Very few press articles would say that “Sterling rose yesterday because it was at the wrong price to begin with” or that “Sterling rose yesterday for no discernible reason, because markets are notoriously chaotic in the short term and a whole host of relatively random forces can influence prices.”
It is interesting that we are drawn to these arguments, because very few people accept the notion of ‘strong form efficiency:’ the idea that asset prices already reflect all the information that is out there and only new information can cause them to move. If we did then there would be no active management.
The reason people do think they can make money through active management is that they believe in inefficiencies; areas of mispricing that should correct over time or provide attractive compensation relative to true risk. In the episode team we think these inefficiencies can come from various sources: investors may be too concerned about the short term, they might become overconfident about the future, and they might focus too much on a single issue, ignoring the true complexity of the world. We also believe that when investors are confronted by confusing structural changes to the economic system there can be a high likelihood of herding and overshoots.
Could it be that these forces were at play in Sterling prior to yesterday’s speech? We have certainly seen very rapid short term currency moves and deep uncertainty about what shape the future regime for Sterling and the UK economy will take.
You can add to this that the nature of price means that it would ‘feel’ very uncomfortable for investors to take the opposite view, many are focusing on Brexit as the only issue driving Sterling and ignoring both influences on other currencies and other forces that can shape the UK economy.
All these together mean that it is not unreasonable to suggest that Sterling went up yesterday, simply because it wasn’t efficiently priced in the first place. It is dangerous to read too much into every twist and turn in the market; it causes confusion and can distract investors from the issues that really matter.