GBPUSD – Peak Shifts, Macrotrends, True Bottom and a Settling Sterling

Since Sterling hit its 2016 nadir in October of that year, despite significant headwinds, the British currency has staged quite a remarkable comeback, climbing from lows of $1.19 to $1.39 this January. This is a near 15% pull-back over the past sixteen months. What is also significant is that while bears have been expecting that each rally for the Pound is merely a correction, it appears that quite the opposite has been the case. Each downward shift after a recent high is followed by a further high, whilst each following low bottoms out at a higher point.

The question has become whether this current over one year upward climb for the Pound is here to stay, or whether it is merely indicative of a longer rally, that will ultimately see Sterling settle lower. This article focuses on such macro trends from a historical and political standpoint, suggesting that what we may be seeing is the establishment of longer-term post-Brexit levels of true resistance and support for Sterling.

A Brief History '08-'18

During the financial crisis of 2008, Sterling hit lows of $1.34, and until July of 2014 the Pound followed a rise and dip trend on an upward trajectory, culminating in highs of $1.71, yet soon after, and prior to what some might gladly term the Brexit debacle, precisely the opposite pattern was working itself out, with the Pound looking to settle lower, roughly somewhere between $1.40 an $1.50. History, of course, turned out differently, and the Pound had little chance to settle over the next few years. More recent events quite obviously had a negative impact.

Although speculative, it is not too great a leap to suggest that the Pound would have levelled out at a value above the current highs that are sparking increased media coverage. Undoubtedly though the decline appears to have been arrested, and doom-sayers who spoke of the possibility of dollar parity appear to have been silenced.

What Next is Presaged by What Came Before

An awful lot of market movements come down to one thing: sentiment. Yes, the breadth, depth, and excellence of the technical analysis out there ought not to be underplayed, and for day-traders it is absolutely essential, however when looking at the macro-trends of a currency's movements; when to keep a long holding, and, of course, when not to; paradigm shifts and gut feelings matter as much as fundamentals. As always the bear and bull and the hawk and dove are to hand as simple analogies, however when you look at Sterling, and the British economy in general, especially through a historical FX-based lens, another image comes to mind: the volcano.

What some scholars have called axial ages, greater historical periods that shift and move global events, certainly can be applied to British history over the past 1,000 years. From the lows of the imposition of the Dane Law, when Britain had to pay tribute to Viking raiders, to the economic highs (ignoring for the purposes of argument the social and political issues) of Empire, the British economy seemed to have been working itself up ever higher in a financial frenzy until it erupted onto the world.

Since such highs, arguably datable to either the high Victorian period when the GBPUSD exchange rate stood at $9.97, or the pre-WWII highs of empire at around $5, Sterling has been following that rising and falling trend on a consistently downward trajectory. The volcano is still active, but dormancy appears ever closer. Nevertheless, whilst Britain is unlikely, without significant changes, to rise to the heights it once occupied, it is equally improbable that the downward-trend will continue forever.

Geopolitical debate has long relegated Britain to the status of a second-rate power, and Sterling's status has followed a similar path. Britain's is a predominantly low-wage service economy, with several hub-cities, for instance London, Edinburgh, and to a degree Manchester, that provide more to the economy, most particularly in finance and technology. This is the reason that a Sterling renaissance to pre-crash levels is hugely unlikely. The crash merely amplified the underlying paradigm shift that had affected the British economy on a grass-roots level for a number of years.

What will happen, however, and more than likely soon, albeit after the Brexit farrago has worked itself out, is that we are likely to see Sterling hit what could be called true bottom. For all the cynicism, there is a significant dynamism underpinning the British economy, above and beyond factors of whether or not it stays in the single market, or which shade of politics rules the nation.

The real question then becomes how close are we? The answer, of course, can only be speculative, but it certainly seems like the gut feeling at-large is that that bottom point is closer than might often be imagined. Yet, as a result of the rally of these last sixteen months, the number of short calls are likely to increase in an inverted form of the boy who cried wolf. If you call wolf enough, the wolf will always come.

Indeed, unless Britain's hitherto haphazard negotiators manage to spectacularly fail and we see Britain crashing out of the European Union without a deal, it seems certain that those $1.19 post-Brexit lowswill not be broken. Remember that these negotiators have, correctly from an economic standpoint, caved in on every EU demand, despite doing their utmost to demonstrate the least amount political competence and cohesion possible.

Should Britain crash out without a deal from the EU, thattrue bottom will, of course, be tested, and $1.10-$1.15 could come into sight as a possibility. Nevertheless, barring a complete breakdown in the type of political reason that helped that erstwhile British volcano to explode in the first place, this is extremely unlikely. This being the case, it is probable that Sterling will stabilise somewhere between pre-Brexit lows, and post-Brexit highs, depending on the final deal with the EU, somewhere between $1.35 and $1.45.

Rewards and Rectangles – Peak Shifts

Theorists V.S. Ramachandran and William Hirstein, in a paper encompassing network theory and aesthetics, note the importance of the peak shift principle in studying behavioural patterns and macro-trends. The peak shift principle, loosely put, is the idea that on determining a pattern that to all intensive purposes appears to be a rule, the perceiving agent will continue to act in response to that pattern incrementally.

“If a rat is taught to discriminate a square from a rectangle … and rewarded for [discriminating] the rectangle, it will soon learn to respond more frequently to the rectangle,” they write. “However, the rat's response to a rectangle that is even longer and skinnier is even greater than to the original prototype on which it was trained.”

At first glance this principle, although undoubtedly interesting, has nothing to do with the macro-trends this article discusses. That said, since the current trade in Sterling is heavily driven by sentiment, as against cold hard fact, it would seem very much to apply. The major governing paradigm behind moves in the Sterling exchange rate is Brexit, as most analysts agree, yet a pattern can be discerned that suggests the market is following the peak shift principle towards greaterinstances of form.

The no-deal vs deal camps have veered towards the type of caricature response/reward paradigm Ramachandran and Hirstein noted. The market is thus responding appropriately by recognising which of the two sides appears to presently be winning, and following the economically logical paradigm that a deal is a good thing. Eventually, however, this kind of 'caricature' leads to a form of lazy thinking that undermines the true value proposition that prompted it.

If Sterling approaches pre-Brexit highs, as it has done, when the economy is in worse shape than it was, and the political situation continues to be fluid, the niggling feeling exists that the blind are leading the blind, and that present Sterling rises and falls, most particularly the rises, are to a degree being reduced to a two-sided pantomime supported by the present weakness in rival currencies and a rise in British interest rates.

Ultimately, caricature veers toward farce, unless the underlying rule holds true. This being the case,a valuation for Sterling much higher than present levels, in the long-run would appear to be more than likely speculative, unless the Brexit decision is reversed, a Norway-plus option is agreed, or a remarkably pro-British black swan finds itself landing in one of London's famous parks.

Conclusion

Whilst perhaps not a typical day-to-day analysis of the present exchange rate trends impacting on Sterling, this article, by considering macro-trends, is intended to present the case that a long position on Sterling is not necessarily a fools game, nor is shorting the currency at present levels. The simple truth seems to be that, barring the unexpected, the maximum likely lows have been tested, and now the highs are also being challenged, prior to the turbulence to come when round two of Brexit negotiations begin.

Highs above pre-Brexit levels certainly would seem to indicate speculation as against strength, whilst lows below that $1.30 range deemed psychologically important not so long ago, would also seem unlikely at present. This being the case, in answer to the question first posed at the outset of this article, the rally may well be set to stay in the short term, but as negotiations begin again, barring the Norway-plus/no-Brexit option, Sterling is likely to settle lower than the highs it presently tests.