Sterling plunged over 6 percent against the US dollar within three minutes to 1.1841 last week, hitting its lowest level in 31 years.
While it has seen a moderate rebound since then, the flash crash points to further downside, as historical patterns suggest.
By defining flash crash as a drop of 3.9 percent or more within three trading days, we can find 45 times that such a drastic decline has happened since 1976, including the one last week.
In 73 percent of those cases, the pound fell further in three months’ time.
There are a number of other factors pointing to a weaker pound.
As the UK government seems to be leaning towards a “hard Brexit”, investors will be increasingly concerned about the negative economic impact.
Concerns over a country’s deteriorating economic conditions typically point to a weaker currency.
Besides, diverging monetary policies between the Federal Reserve and the Bank of England are likely to weigh on the pound.
The US Federal Reserve ended its quantitative easing in 2014 but the Bank of England is being forced to pump more liquidity into the market to offset market shocks from Britain’s decision to leave the European Union.
The monetary base ratio between the United States and the United Kingdom has been falling in recent years, coinciding with the weakness of the pound against the US dollar.
Since the policy divergence is expected to continue for quite some time, there will be more pressure on the pound.
The latest data from the US Commodity Futures Trading Commission measuring non-commercial British pound positions saw a record number of short positions, 94,000 lots, at the end of last week.
That indicates that big investors in futures market are fairly bearish on the pound and have positioned accordingly.
Although the pound might now look oversold – and it won’t be surprising to see a short squeeze in the near term – there is a good chance that it will eventually sink below the recent low of 1.1841.
This article appeared in the Hong Kong Economic Journal on Oct. 13.
Translation by Julie Zhu
[Chinese version 中文版]
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