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Weekly Market Update

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(Quantitative) Easing Like A Sunday Morning

Tue, Oct 20 2009, 09:48 GMT
by Alex Sullivan

World First UK Ltd

Last week was turbulent. We began the week with ominous news from the CERB regarding sterling interest rates. They predicted that interest would remain below 2% until at least 2014 and that sterling’s valuation would fall below parity against the euro. All scary stuff and it rightly set the tone for a seasonally spooky week for all sterling sellers. With such fundamental measures of a currencies value such as interest rate predictions signaling that all is not well it was imperative that inflation data came out strongly positive. Inflation is an especially important measure in light of the UK’s extensive QE scheme. We would expect that artificially flooding the UK economy with £175bn would cause a strong inflationary pressure. If this is the case the BoE has very little room to extend the scheme. Currently, one of the spectres haunting sterling is the possibility of further extension to the QE scheme and this would certainly force sterling downward against all crosses.

The fact that inflation came out at 1.1% was of major concern. This signaled to market that the possibility was there for the BoE to extend QE and as such sterling was annihilated in the first part of the week. This then gave rise to concerns that sterling would reach parity sooner rather later. There was a strong feeling in the market that the BoE would extend QE. This belief, bolstered by inflation data, had risen out of previous BoE minutes in which the voting signaled several members, included Governor King, had wanted to extend QE by a greater amount than the £25bn agreed back in August. Furthermore, the greatly publicised GDP VS debt Ratio problem will be further highlighted if the BoE do continue to expand QE. This bring the validity of the UK AAA credit rating back into consideration and if the UK were to lose this it would have major implication on the UK economy. It would mean that gilt yields would have to increase and that the weightings of government assets held by pension funds would have to undergo a dramatic rebalancing.

So, it came as no surprise that sterling rallied on Thursday thanks to comments made by BoE member Fisher that QE was having the scale and speed of impact that the bank expected. It was further good news from the Bank with comment from Deputy Governor Bean stating clearly that QE would need be suspended should the bank reach their 2% inflation rate. We should contrast this news with that sterling still appears to be undervalued against euro by about 9%. However, whilst in a long term macroeconomic cycle this undervaluation should come out in the wash short term trading on this information is known as trying to ‘catch a falling knife’; you’re very likely to hurt yourself should you attempt to. The main reason for this undervaluation is down to the uncertainty that lies with the UK economy and the prospects on the political landscape.

This week we have some major event risk surrounding the BoE minutes released on Wednesday and the Q3 GDP figure released on Friday. We are anticipating a positive, albeit by the skin UK’s collective teeth, GBP figure. Although signaling we are out recession it will far from signal that we are back living in the land of milk and honey. The picture that is appearing evermore is that we are in an economic limbo. The only thing to do is to sit tight and hope we can ride this out.

Trade of the Week

This week’s trade of the week is a Convertible forward until February. For a GBP seller and a buyer of USD, this client took advantage of the uncertainty in GBPUSD in order to protect himself against falls whilst being able to benefit should the market turn higher.

The client was able to achieve a worst case rate of 1.61 on his option which allows the client to benefit all the way up to a rate of 1.76. Should the rate touch 1.76 during the barrier period (1 month before the expiry date) then the structure reverts to a forward at 1.61.

This strategy requires no premium, and is also relevant for buyers of sterling and sellers of other currencies. As there is a potential further weakening for sterling in the future, it provides a balanced upside for this potential, while guaranteeing a tight WCR.

Published on  Tue, Oct 20 2009, 09:49 GMT