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Forex Blog - UK Credit Repricing Overdue

UK Credit Repricing Overdue

 

The sell-off in GBP today is nothing short of eye popping.   While the casual causality displayed in the financial press in explaining the dive in the pound and rise in Gilt yields was predictable.; weekend polls showing a dead heat between Labour and the Conservatives (hung parliament) and a M&A deal (Prudential of the UK buying AIG’s HK business for $35.5bln with mostly a cash offering.  Seems perfectly sound on the surface however there is nothing new in the opinion polls (pointing at hung parliament for weeks) and who in their right mind believes the Treasurer at Prudential is in the market now buying USD for GBP to the tune of $25bln? 

 

Sterling is down because the EU has moved ever closer to guaranteeing Greek debt so the government there can get some much needed financing (issue debt at a less than usurious rate) and avoid default.  With a life vest apparently on Greece, and sovereign risk the main trading theme of 2010, it is natural that the market move to UK credit concerns as the lifeline for Greece surely would be offered to the more compliant of the recalcitrant EMU states like Portugal and Spain (though the scale of any bailout rises proportionately with the size of the economy and problem).  After all the UK has a AAA rating and is borrowing at rates closer to a AA than a AAA credit.  Since when do we have to wait for a downgrade on UK to sell the currency and Gilts? The rating agencies’ track record is poor even on timely sovereign credits ahead of crises in the past like Asia, Mexico, Russia and Brazil

 

Don’t get me wrong, UK sovereign risk is not Greece sovereign risk and the two do not belong in the same boiling cauldron while hungry speculators await the dinner bell (kidding – banks equally behind the run up in CDS on weak credits s they cover counterparty risk in credit lines and derivatives to the likes of Greece.  But there is room for markets to adjust risk in light of large and growing UK deficits, still moderate growth and the potential for political gridlock (anyone that says gridlock is good for markets ought to be exiled from the financial markets). 

 

While markets priced in lots of extra risk for the UK today (and recovered from worst levels) there should be scope for more ahead (it’s a long wait until the May election – not yet officially called but odds makers are going with early May), especially on levels for the pound (I like retest of the January 2009 low at 1.35).  And there is scope for the 10-yr Gilt yield to rise to 4.50-65% on elevated sovereign risk.  Also look for more movement in UK CDS (outward or the cost of insuring against default rises).  Assuming regulators don’t crack down on CDS OTC market (see fed statement today on efforts by the Street to make the market more transparent – fear of god is in this market as some regulators and lobbyists want the Congress to move it all to an exchange) we think CDS spreads in the developed world are too low and conversely too high in the developing markets and see convergence here ahead.

 

I also think CDS on US municipalities against some developing sovereign CDS makes sense as well…mini-Greek events lie in wait here with the federal government of the good old USA providing the backstop in the face of funding crises.  And in due course CDS on USA has loads of scope to move outward, though this trade will require real patience and more evidence of a double dip recession or even L-shaped “recovery” to unfold. 

 

Until then I still like the USD against most currencies, though downside in CAD should be limited (even MXN trading more like a shadow currency along the lines of CHF to the EUR).  But I also sense that to see the breakdown in cable spread to EURUSD and USD index (take out the Feb 19 low and high respectively) we need to see US stocks dive and this trade is elusive.  I see waxing and waning of correlations, but for the really big market moves in USD, stocks, commodities and UST, we need to see very tight correlation and missing in a number of the large moves up in the dollar since early February has been a marked decline in stocks.  And even as wrong as I have been on stocks to date, I still hold on to the view that flat or weak private sector economic activity in the US and globally is not a supportive backdrop for riskier asset prices like stocks.  And as the Fed begins to turn down the liquidity spigot even at the margins…the message should be clear…another key prop for risk assets (abundantly cheap liquidity) is not going to be a permanent state ahead and should assure a large sell off in risk assets like stocks and commodities ahead.

 

David Gilmore

 

 

 

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