(Bloomberg) -- Investors in London woke up Friday to find out the pound plunged 6.1 percent against the dollar in two chaotic minutes early in the Asian day. The world's fourth most-traded currency looked more like a frontier market as volatility soared and traders grasped for a reason.
What caused it?
Analysts speculated that the initial decline may have been sparked by a “fat finger" human error, while others pointed to comments by French President Francois Hollande pushing for the European Union to negotiate hard in Brexit talks. The slide capped a tumultuous week for sterling, that has seen it tumble as Prime Minister Theresa May raised the specter of a Hard Brexit.
Whatever started the slide, computer-driven orders added to the selling pressure, especially because it came at a time of day where there aren't many human traders at their desks and liquidity is particularly thin. The crash happened just after 7 a.m. in Singapore, or midnight in London, and after New York had closed on Thursday. At one point, the bid-ask spread -- the difference between the prices at which dealers buy and sell, which is also a gauge of illiquidity -- jumped to more than 250 times its median during the past year.
“It would seem that it caught the market wrong-footed and triggered a lot of algorithmic selling," said Hugh Killen, Westpac Banking Corp.'s head of trading for foreign exchange, fixed income and commodities, in Sydney.
Has this happened before?
Yes -- at least in other currencies. In January, the South African rand tumbled 9 percent in 15 minutes before rebounding, while New Zealand's dollar had its own flash crash in August.
Moments of extreme volatility in currency markets are getting more common amid regulatory changes that have seen global investment banks pull back from dealing, leaving fewer parties to take the other side of trade. At the same time, algorithmic transactions have more than tripled over the last three years, accounting for almost $200 billion of daily turnover, according to Aite Group, a consultant in Boston.
The pound itself fell more than 11 percent on June 24, as the result of the Brexit referendum became clear, while, in January 2015, the Swiss franc strengthened more than 40 percent when the nation's central bank removed its cap on the currency. The fallout from the latter took months to be resolved, as traders and regulators examined the extent of the move and determined which trades has been executed.
Isn't foreign exchange supposed to be deep and liquid?
The pound-dollar pair is the third most traded in the $5.1 trillion-per-day currency market, according to the Bank for International Settlements. The pair makes up 9.2 percent of all trades, totaling $470 billion per day.
For all that liquidity, there are certain times when trading is lighter. The flash crash came in the “twilight zone,” when “New York were closed and it was prior to Singapore and Tokyo markets opening up so it was a real point of illiquidity,” according to Neil Jones, head of hedge-fund sales at Mizuho Bank Ltd. in London.
The Bank of England is “looking into” the causes of the crash, a spokesman said Friday. BOE Deputy Governor Ben Broadbent said earlier this week that the decline so far had been “relatively orderly.”
Where to from here?
The move took the pound to far weaker levels than most forecasters have been expecting, with surveys by Bloomberg showing they see sterling ending 2016 at $1.28. It traded as low as $1.1841 on Friday, the weakest level since March 1985, according to Bloomberg composite prices. At least one electronic trading platform was said to have recorded a transaction at $1.1378.
Strategists noted that the currency's technical outlook now looks grim. Derek Mumford, a director at Rochford Capital Pty in Sydney, said it's set to drop to $1.15 in the coming weeks if it doesn't recover above $1.28.
With the exact meaning of Brexit still unclear, traders are expecting more volatility. Prime Minister May has pledge to trigger Article 50 of the Lisbon Treaty, the formal step needed to leave the bloc, by the end of March 2017. That would start two years of formal discussions on an exit.
What was the market fallout?
For an event of this magnitude, other markets remained pretty resilient, with Asian stocks and S&P 500 Index futures slipping 0.3 percent as of 8 a.m. in London. The U.K.'s benchmark equity gauge, where exporters have been rallying as the weaker pound buoys the outlook for earnings, advanced. A bigger reaction came in U.K. gilts, which saw 10-year yields climb as much as 10 basis points.
What does the crash mean for the U.K. economy?
Potentially, faster inflation. The weaker currency already pushed up import costs by 9.3 percent in August from a year earlier, the most since 2011, and the pound has fallen 5.3 percent against the dollar since the end of that month. The U.K. 10-year break-even rate, a measure of bond market inflation expectations, has soared this week, reaching the highest since 2014.
While sterling's slide has been a fillip to exports, it's also focusing attention on the difference between money coming into the U.K. and money sent out, with some analysts warning that foreign investors may be less willing to finance the deficit by buying U.K. assets.
The current-account gap was 5.9 percent of gross domestic product in the second quarter, and Bank of England Governor Mark Carney has warned of a reliance on “the kindness of strangers”.
--With assistance from Anooja Debnath To contact the reporter on this story: Sarah McDonald in Singapore at smcdonald23@bloomberg.net. To contact the editors responsible for this story: Sarah McDonald at smcdonald23@bloomberg.net, David Goodman at dgoodman28@bloomberg.net.
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