Why GBP/USD sold off so much today?

THE CATALYST

This early morning, in an exclusive interview with The Guardian, BoE’s Governor Bailey said that the central bank could become “a bit more aggressive” in cutting interest rates provided the news on inflation continued to be good.

That was the catalyst for GBP weakness across the board.

The market’s pricing didn’t change much though, in fact only 3 bps of extra easing were added by year-end. The reason for the big selloff has to do with positioning.

POSITIONING

The magnitude of the market reaction to a repricing in expectations is generally driven by positioning.

Say we are in risk on, so risk assets generally rally together like equities, commodities, commodity currencies and so on.

The magnitude of the moves in each market is determined by positioning. If one of those markets is let’s say net short, there’s much more room to the upside.

Therefore, to get the big moves you should find the markets where a change in expectations can yield the most.

The long positioning in GBP/USD is at a 5-year high. That’s a lot. You can see that in the picture below with the green line showing the speculators positioning.

In comparison, you can see in the EUR/USD chart below that positioning is much less stretched to the upside.

FINAL THOUGHTS

The problem with trends is that they can overextend even if the reasons for the trend start to weaken. Markets tend to overshoot. It’s this behaviour that provides traders with mean reversion opportunities.

Soros once said that he was very cautious
about going against the herd and most of the time he followed the trend. All
the time, he was aware of being part of the herd and he was always on the
lookout for inflection points.

When the reasons
to follow the trend start to weaken and you begin to see signs of a change,
that’s when you can build a contrarian thesis. Your thesis might not come to
fruition though without a catalyst. You generally need something to trigger
your view and get the market to follow it.

Keep it in mind in case the US data in the next months causes the market to reprice the aggressive dovish expectations or the UK data leads the BoE to go a bit more aggressive.

This article was written by Giuseppe Dellamotta at www.forexlive.com.