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At the end of what was another eventful week on financial markets a lot of us were left thinking “how on earth could a trader rack up losses of $2.3 billion and no one notice until now?” If the UBS rogue trader, Kweku Adeboli, could pick anyone’s brains as to how to structure his defence, George Osborne would probably come top of the list.
Our chancellor seems to have overlooked a £12 billion funding gap in public finances just two months prior to his autumn statement on 29th November. The word you are looking for is “whoops”. Forget about debating the 50p tax rate, the coalition now faces either prolonging austerity measures or hiking taxes. The issue with increased austerity measures or hiking taxes is that both tactics take money out of the economy and put a greater squeeze on the average household. Data released last week would indicate we need the exact opposite to happen and therein lies the conundrum.

Unemployment rose to 7.9% and retail sales contracted by 0.2% in August. Part of the drop in retail sales has been attributed to the nationwide riots that forced shops to close early and kept consumers off the streets. The hope is that September’s figure shows a significant bounce back. However, unemployment is due to remain stubbornly high for the foreseeable future. It’s not just rising unemployment but also low wage growth that is making a significant dent in consumer’s buying power. The consumer price index pushed on to 4.5% in August, way above the 2% target rate which has a similar effect as falling wages. The figure is still forecast to peak at 5% and then start to fall throughout 2012 in line with VAT returning to the 17.5% level. But if the government now has to plug a £12 billion size hole, an increase in VAT may be a more likely scenario.

Thankfully it looks almost certain that more QE is on the way. Published today, the BoE’s quarterly bulletin concluded that “the full effect of QE was equivalent to a 150 to 300 basis point cut in Bank rate, a significant reduction”. The report aside, what else could we do?

Key releases for Sterling this week

Nationwide consumer confidence out on Tuesday – we are expecting a poor reading which will be mildly bearish for Sterling.

Bank of England interest rate meeting minutes out on Wednesday at 9.30am – we are expecting 3 of the MPC to have voted in favour of further QE. This will be bearish for Sterling but bullish for the FTSE.

Jeremy’s trade of the week

This week’s trade of the week is a ‘Participating Forward Out’. This differs from the usual participating forward in that, for an increased risk, your strike improves from 1.1250 to 1.15 against a forward rate of 1.15. The client decided to hedge his next 6 months of exposure via this trade.

The client will benefit in 50% of any upward movement i.e. should GBPEUR be 1.23 on expiry, 8 cents better than the strike rate, the client receives 1.19 averaged, 4.00 cents better than the strike rate. Should the GBPEUR rate be below 1.1500 and above 1.0800 on expiry they are able to buy euros at 1.1500, if it touches 1.08 however within the monthly window then protection at 1.15 is lost and you are un-hedged for the month.

This strategy is premium free and allows a hedge at the current forward rate while a normal participating forward would see a worst case rate a further 2.5 cents lower. This structure has proved popular for 2 reasons. Firstly it allows the client to obtain a strike at current market and secondly, with markets volatile at the moment provides a balanced risk/reward as part of a hedging portfolio. As such we would recommend that this trade is taken alongside a structure that provides a concrete worst case rate.

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