Toughest week for the coalition ahead

andres del risco

The latest global growth predictions from the Organisation for Economic Co-operation and Development (OECD) were released this morning and needless to say they made fairly grim reading. You could summarise it briefly by saying that the body believes that the global growth situation will continue to deteriorate in the coming months, but that a significant short, sharp drop lower cannot be ruled out as a result of the situation in Europe. In any case, central banks should be printing money to keep economies going (that includes you Frankfurt) although these moves will not be enough to keep the Eurozone and UK out of recession in the short-term. Gulp.

Britain’s output will fall by 0.1% in Q4 of 2011 and by 0.6 % in the first three months of next year, before picking up during the rest of the year fulfilling the textbook definition of a recession of 2 consecutive quarters of contraction. Growth will only total around 0.5% in 2011 as a result, which is a significant downgrade from the 1.8% that they had forecast in May.

Obviously this comes only a day before the Office of Budgetary Responsibility issues its latest forecasts for the UK economy, with journalists expressing surprise at the amount of briefing they are receiving before the report. Normally a sure fire sign that the actual product is likely to be a bit of a bloodbath. In June, they said that the structural deficit would be wiped out by the end of 2014/2015. However, it is expected to revise its forecast, and state that this target will only be met if the government maintains the real-terms freeze on spending until 2017. Not what Osborne wanted to hear at all.

Sterling has been relatively resilient in the past few weeks versus the euro, but it has really had some lumps taken out of it versus the dollar and yen as the moves into haven currencies increases. Flows into typical safe havens in currency markets, such as USD and JPY, have been strong – as have moves into USTs and JGBs alongside UK gilt purchases. While the UK is seen as a safer asset than most European products, the pound is getting killed against the havens. 10 days of falls on equity markets are expected to continue next week and we have to remember that GBP rarely trades well in low liquidity environments – the past four December’s have seen GBP lose 3.3% on average versus the USD (which would equal 1.5050 at the time of writing). The trade below is ideally placed to make sure this does not hurt you going forward.

Combine this with planned strike action on Wednesday and it is easy to see that this week may well be the most testing for the coalition government yet.

Jeremy’s trade of the week
This week’s trade of the week is a Leveraged Windowed Convertible Bonus with the client wanting to hedge their dollar exposure Jan to June 2012. He buys dollars and sells sterling and wanted to protect a budget level of 1.55.

The structure gave the client a protection rate of 1.55 (forward price) to buy dollars however should spot on expiry be below 1.55 your worst case rate is ‘boosted’ by the cent difference between the spot rate and 1.55 i.e. if spot on expiry is 1.50 then the client receives 1.60. This applies as long as the rate is not below 1.46 in that month, If it is then your bonus doesn’t exist that month and you are simply protected at 1.55. Obviously this structure gives you a benefit to the upside as well and the client is able to benefit up to a level of 1.66. If the rate touches the 1.66 during the month before expiry however he must buy 2.0x the amount of dollars at 1.55.

This strategy requires no premium, and the use of leverage allowed the client to increase both his level of protection and the barriers that he can benefit up to. As there is a potential further strengthening for sterling in the future the structure allows for a large amount of beneficial movement whilst always protecting against adverse moves.

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Toughest week for the coalition ahead

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