Sunday, November 29, 2009

The UK economy and signals from the CDS market.

According to David Oakley of the FT, the latest credit default swap price shows the cost of insuring UK government debt has increased by £20,000 to £70,000 a year for every £10m debt. An increase of 40% within a space of a month.

Why is the CDS market pricing in such a huge increase and why is the long end of the UK gilt market not following suit? Rather than see gilt prices move in tandem with the CDS market, we have seen yield on 10 years UK government debt head south? Are bond vigilantes asleep at the wheels or is this a short term phenomenon? What are bond vigilantes focusing on at the moment? Is it inflation, risk or the long term growth rate of the UK economy?

Below is the latest comment from standard and poors on the UK economy.
"We have revised the outlook on the UK economy to negative due to our view that even assuming additional fiscal tighthening, the general government debt burden could approach 100% of GDP and remain near that level in the medium"
David oakley further states ".........the UK is heading for a budget deficit this fiscal year of 12.4% and a net debt as a percentage of GDP of 55.4%."

Policy inconsistency:
It is our believe that the policy of quantitative easing (QE) being adopted by the BOE is the wrong approach. Interest rate of 0.5% and £200 billion spent so far have failed to lift the UK economy from its current state.

While we commend the BOE and the UK govt. for taking steps to stabilise the banking system, we however see the continued purchase of gilts in the name of QE as an exercise in futility.

The current recession in the UK is a balance sheet recession, where both firms and households have ever increasing liabilities with falling assets. Hence the astronomical increase in the rate of IVAs and bankruptcies within households and firms alike.

Rather than focus its monetary and fiscal policies in addressing these issues, the BOE and the UK govt have decided to keep pumping money into the banking system.
This so called balance sheet recession has destroyed aggregate demand and we expect monetary and fisscal policies to address these issues.

We expect the UK govt to reduce its vat rate to 10%, reduce basic rate of tax to 15% and the BOE should maintain an expansionary monetary policy for the next 2 years or so. These measures in the short run will increase government debt but will increase disposable income, which will then speed up the process of balance sheet repair by households and firms. Spending by households and firm will then increase. Aggregate demand will then return, investment spending will also increase and job creation will follow suit.

Anything short of this is a recipe for disaster and hence the reason why UK CDS prices are increasing. The hard nosed investors are beginning to smell blood and hence positioning themselves for the day of armageddon!!

Our recommendation:

1) Short the pounds: The cable is caught within a range of 1.64 and 1.68. We would establish a short if the the cable gets to 1.70. Why we believe this as a good trade is that the BOE is in no mood to see the sterling rise and for 2 reasons:
a) The BOE sees the export sector as the one sector that can get the UK out of its current state. Hence a devalued sterling is good news to exporters.
b) The BOE wants inflation back to its target range of 2%. An appreciating currency will negate this target.

2) Put in a curve steepner trade: We believe shorting the long end of the UK yield curve and long the short end is the right trade to place. If the CDS market is right, we believe investors will soon begin to demand higher yield for holding UK government debt.

3) Long UK CDS Debt: For those who have access to the credit market initiating a long UK debt CDS will be best option.

Please note these trades are medium to long term trades and should be implemented using the options market.

From Mr Olu Omidire (FCCA).

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