Range trading on the back of some bad news...

The S&P rallied in the early part of this week, mainly on the back of good GDP news at the end of last week. However, a mixed bag of news surrounding jobless claims in the US, concern governments will struggle to fund their budget deficits in Europe, strikes in Greece promted by spending cuts and the BoE deciding against further quantitive easing has caused the market to drop sharply today.

Worth noting that both the BoE and the ECB have held rates at 0.5% and 1.0% respectively.

The BoE decision in relation to QE looks to be driven by inflationary concerns. This may put upwards pressure on interest rates. However, the ECB and the FED have signalled the intention of keeping rates at their current levels for an extended period. In the UK growth was lower than expected at 0.1% which is leading many analysts to expect that rates will remain low to avoid falling back into recession.

All good news for my portfolio which is net short. I had cut my S&P short on Monday @ 1080 following the rally. I since opened another short close to the top of the range @ 1097 which is looking healthy. I am sitting on the BAC, AAL and PRU positions. The Dollar trade is also looking good especially on the back of the jobless claims news out of the US. All in all, I am still bearish.

Is cutting interest rates a good idea?

It has been a hell of a long time since my last post! I have been off enjoying myself in Vegas before the Xmas break and Mauritius post New Year. The economic, financial and political world gone through a great deal since my last post - the inauguration of Obama in the US, more government bailout's on the cards, terrible unemployment (Q4 2008 1.92m, highest level since 1997) and GDP (Q4 2008 -1.5%, official recession confirmed by 2 consecutive quarters of negative growth) figures confirming the recession is with us, the Israel-Gaza conflict, just to name a few.

The latest piece of news announced today is that the BoE base rate has been cut by 50bps to a record low of 1% - the 5th interest rate cut since October. The aim is obvious - to attempt to stimulate lending and to boost the shrinking economy. Good news for industrialists, retailers, builders and estate agents. However, as I have written about previously, I completely disagree with the notion that we should try to borrow our way out of trouble, hence I think the rate cut is yet another wild decision by the powers that be.

Firstly, it is terrible news for savers and creates moral hazard. Those who were prudent enough to save when things were booming no longer have the same incentive especially when they see bail outs for the careless being handed out left, right and centre. It is as if they want people to get themselves into more debt that they can't pay off rather than save which is what caused this crash in the first place! What the BoE seem not to understand is that by paying lower rates there is less of a chance that people will keep their cash in the bank or building society. The result, fewer funds become available for borrowers and the effect of the interest rate cut is nullified.

Secondly, the damage to sterling could be horrendous. Lower rates means lower returns for foreign investors in sterling denominated products. That gives them less of an incentive to hold sterling, lowering it's value. The more the pound devalues, the more reluctant external holders are to own it. The implications are that in order to service the massive national debt which is estimated to be well over £1 trillion within 5 years, the government will have to issue hundred of billions of pounds worth of gilts. And if external investors do not want to invest in sterling assets, who will buy the gilts?! Unless the government offer higher rates to entice investors - so by cutting the base rate, the long term rate of interest that we'll have to shell out is forced up.

A look back at recent history points to the Japanese interest rate cut to nearly zero in 1995. All that succeeded in doing was shattering confidence so badly that the economy suffered the so-called “lost decade” of collapsing property and share prices. In fact, the Nikkei 225 index is now no higher than it was fully 26 years ago. The bottom line? Lowering interest rates from 5.5% made sense. Cutting them now is a big mistake. Unfortunately, the Bank of England has struggled to work that out.

Big drop in Inflation - good or bad news?!

Every couple of days it seems there is an economic release which triggers a change of sentiment. As a consequence of the drop in the base rate and a fall in commodity prices, inflation has fallen from 5.2% in September to 4.5% in October - the biggest drop in 16 yrs! Despite the drop, the rate is still well above the BoE's 2% target.

So is this good or bad news?

A few months ago, inflation was the main concern for the Monetary Policy Committee (MPC). Inflation was above the 2% target and the pressure was on the MPC to curb the rise in prices. The problem was that the economic outlook was also bleak so there were two separate forces pulling the committee. Preceding the minutes of the MPC's interest rate decision meeting published today, Tim Besley (a member of the committee) cited that "the outlook for inflation had changed dramatically between August and the rate cut in early November. "

The rate cut was a tool to encourage consumer spending and to lower the cost of borrowing. The effect of this (if it works) is inflation. But the problem is that people are not spending money - despite the rate cut people would rather save because there is no short term confidence. Add that to falling commodity prices and we have a new buzz word - deflation.

Deflation in the short term is a not necessarily a bad thing - prices fall which encourages people to spend. The knock on effect into the medium term however, is dangerous. In prolonged periods of deflation, consumers hold off buying goods, reckoning they will be cheaper later. This can lead to further falls in demand and output. As firms sell less, they respond by cutting jobs or cutting wages. Overall, consumers then have less money to spend - and demand falls yet again. And the spiral continues....

What this means is that we can expect further cuts from the BoE in the next few months as they try to avoid deflationary pressures. Good news for borrowers, terrible news for savers.

The key point I would like to note is how the BoE's sentiment has changed so quickly. One second inflation is the worry, they react (quite late I must add...a criticism which has been frequently aimed towards the MPC) and now deflation is the worry. It strikes me that the mandate which gives the BoE monetary control over inflation is nothing but a political tool.

Controlling inflation through interest rates is virtually impossible in the UK because we are so reliant on imports. The UK runs on a current account deficit - we import more than we export - and the cost of imports is determined by the cost of inputs (raw materials, labour etc) in the exporting country and the relative strength of the importing currency. The pound is weakening so the cost of importing has gone up so we should be seeing inflation. However, the the cost of raw materials is decreasing, which suggests deflation. So the overall effect is determined by these offsetting factors.

We are seeing falling inflation due to the culmination of decreased consumer spending caused by the bleak economic outlook which suggests that the fall in the price of raw materials is greater than the pound has devalued (arguable point). What I predict will happen is that we will see the fall in inflation overshoot into deflation for one simple reason - the MPC are reactionary. They act to and not in anticipation of the future economic climate. Some may even argue that their goal of controlling inflation is redundant since there are so many externalities involved that their weapon of choice namely interest rates, is not influential enough to make a difference.

I can see the reasoning behind both schools of thought. My opinion is that, regardless of which one you agree with, expecting the MPC to control inflation is an absolute joke!

FTSE......

And another great call if I do say so myself!

FTSE hit 4075 mark early on Tuesday morning before retracing back to 4200 mark. Was trading in that channel for a while until falling heavily today. As I write this, it has fallen below the 4075 mark with next support at 3945. I expect a retrace back to 4075 where another shorting opportunity may arise.

A bold move by the BoE

End of my first week writing this blog and what a week it has been. We've seen Lewis Hamilton become the youngest ever F1 Champion, Barack Obama become the first black president of the United States and the BoE unexpectedly slashed interest rates by 150bps - the biggest cut since 1981! The ECB also cut rates by 50bps.

The reasoning behind the rate cut is simple - to stimulate lending and revive the credit markets. Bad news for savers but good news for mortgage holders...well not quite. If you have a tracker mortgage (which tracks the BoE base rate) then happy days. Otherwise, it is still not known whether the cut will be passed on by the banks...I know a couple of banks have said they will be passing on discounts on their variable rate deals but others have withdrawn some products altogether (an interesting stat I read recently - the number of mortgage products available in the market has fallen from 15,000 a year ago to just 5,000 now - a fact that will not be helped by the concentration of the retail banking market which will lead to less competition and higher prices). The UK Council of Mortgage Lenders has said that its members would not automatically pass a base rate reduction on to customers in the form of cheaper loans.

They blamed this on a “dislocation” between the base rate and the higher interbank borrowing rates. LIBOR, which is more relevant to banks when pricing credit, is still high despite falling below 6% this week. This means that banks are finding it harder and expensive to borrow money which impacts the consumer. Easily available credit is what caused this crisis in the first place. The banks are now risk averse - they are not willing to lend as readily - and if they do they want to levy a risk premium. So don't expect things to change dramatically anytime soon.

Was the decision a good one - well only time will tell. The markets were expecting a 50bps cut so the initial shock was a good one. I can think of a few reasons for the size of the cut; (i) to keep up with the US and Japan whose rates are extremely low; (ii) to force the banks to pass on at least some of the cut onto customers; and (iii) because they realised the sheer severity of the recession that is ahead of us and a realisation hit that they should have acted earlier (see Robert Preston's blog on the BBC website).

Other bits worthy of a mention - M&S reported 34% fall in profits; BA have reported a 91.6% fall in half year profits ; BT issued a profit warning which sent its shares below the 1984 floatation price; a Goldman Sachs fund posted $990m loss after 10 months trading; the IMF have predicted the British economy will shrink by 1.3% in 2009 and will be the worst performing of the developed economies; house prices down 2.2% in October according to the Halifax, brings total drop to 13.7% for the year.

And the FTSE....

Last week was the most successful week in the history of the FTSE100 Index. The FTSE enjoyed a consecutive 6 day winning streak which was probably a combination of excitement around the US presidential election (the markets rallied due to the belief that an Obama victory would lead to the quick implementation of policies and initiatives aimed at fixing the US economy) and in anticipation of rate cuts by the BoE and ECB. That finished on Wednesday when disappointing results from ArcelorMittal and Carlsberg A/S overshadowed the presidential election victory for Obama (the so called 'Obama bounce' never materialised). Add to this the terrible UK factory production and services figures which cemented the opinion that the country is heading for a recession. Yesterday property developers led the decline following news about a further fall in house prices.

This tells me that the current rally in the FTSE is no more than a temporary bull in a bear market. The trend is still down - a grim economic outlook for both the US and Europe will be the main factor driving the trend. Expect the markets to continue to be volatile.

Points worth noting (those in bold are major):

Support – 4200 ; 4165 ; 4335 ; 4830 (previous support may become resistance)
Resistance – 4440; 4545 ; 5065