World First Sterling Update

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I really had hoped that we would be able to avoid talking about peripheral Europe once March’s Greek bond payment and orderly default on its debt was out of the way. I yearned for an opportunity to focus on the rebounding global economy and was eager to bring news of tranquillity on the global markets. This momentary lull lasted for all of a couple of weeks and now I find myself once more poring over bond yields, previous auctions and central bank intervention. The focus has of course shifted from Italy to Spain in the past month, as Mariano Rajoy’s 100 day honeymoon as Spanish Prime Minister has come to a rather sudden and painful stop.

Greece and Portugal’s problems were born of an ingrained lack of competitiveness in the private sector and a bloated and decrepit public sector that made up far too much of output. Ireland was taken down by a banking sector that got too big for its boots, and when the funding markets dried up following the collapse of Lehman Brothers, the called-in loans were not enough to meet the shortfall. The Irish state nationalised the banks but left themselves hamstrung as a result.

The problems for Spain are more numerous and it seems that only the size of the economy has managed to keep the wolves from the door for so long. The primary symptoms are similar to the remainder of the PIGS however.

Firstly, Spain did borrow a lot of money during the good times. Actually, it borrowed a hell of a lot of money and sprayed it away on projects that provided little long term benefit. Secondly, the state and, in particular, the municipalities and towns’ expenditure created an increase in property prices which Spanish investors were keen to jump on the back of. They borrowed hand over fist from Spanish banks to invest in an inflating property bubble which has of course burst. Most properties were never finished and the Spanish countryside is scarred by so-called ciudades fantasmas: ghost towns.

Much like everywhere in the western world, Spain is struggling for growth and is in the grip of a crippling unemployment issue. Spanish youth unemployment, people between the ages of 18-25, is now within a short hop of 50% while factories and shops lie empty as consumers keep their hands very much in their pockets.

All of this has combined to once again frighten the horses in the markets, sending bond yields soaring and equities sharply lower. The medicine that initially halted this slide for Italy was the European Central Bank buying Italian debt. Officials hinted at a similar operation for Spain last week but this has not been enough to stop the onslaught.

Even if they were to help Spain this way, it will never solve the growth problem. Unfortunately the longer the situation goes unsolved the harder it will become and the more painful on the populace the eventual solution will be. Spain should refuse a bailout and go its own way.

Trade of the Week

This week’s trade of the week is a ‘Double Leveraged Seagull”. This differs from the usual risk reversal in that, for an increased risk, the client’s strike improved by 2 cents. The client decided to hedge his 1st quarter of 2013 with this trade to lock in some of the gain in GBPEUR we have seen recently.

The client’s strike was set at 1.2000 on his option which allows the client to benefit all the way up to a rate of 1.25. If on expiry the rate is above your cap level then you must buy 2x the amount at that cap. He is of course able to trade at spot between 1.20 and 1.25 if the barrier is not touched. The added risk is should GBPEUR fall below 1.1200 then for every percentage point below 1.1200 then he loses the same off the strike of 1.2000. if the rate is not below 1.1200 then he is completely protected at 1.2000.

This strategy is premium free and allows a hedge with a strike to the forward while a normal risk reversal would see a WCR at least another 2.5 cents worse. As there is a potential further strengthening for sterling in the future the structure allows for a large amount of beneficial movement.

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World First Sterling Update – Spring breaks Spain

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