Cuts and consequences

IN WESTMINSTER, “the markets” are increasingly attributed sentience and an opinion on the world around them. In the lower chamber, we hear much pontificating on “what the markets want”. Traders in contracts for difference (CFDs) may want to ask the opposite question: if the deficit is not brought under control, or maybe more importantly, is not seen to be brought under control, what will be the market reaction?

According to Michael Hewson at CMC Markets, before last May, UK government gilt yields were worryingly high. Since then they have dropped considerably, a sign of outside confidence that the government is heading in the right direction.

Manoj Ladwa, senior trader at ETX Capital is clear about how abandoning the cuts to government expenditure would affect the UK: “Yield on our sovereign debt would shoot up, spreads on credit default swaps would increase and sterling-dollar would drop. It would become more expensive for Britain to borrow to service its debt.” Angus Campbell, head of sales at Capital Spreads, says that while the austerity measures may be tough, they are necessary: “The main concern when it comes to the cuts is that they’re affecting growth. As such, it makes it very unlikely that the Bank of England will rise interest rates drastically. Should there be a change of view on the cuts, sterling may spike in the very short term, but would steadily decline, maybe without any short term rise.”

Given the enormity of the reaction should the UK shirk from cutting its payments to its creditors and eventually cutting its debts, it is unlikely that we will see a u-turn on the government’s position. However, there is still the risk that the government will not cut hard enough to make an impression.

For those wishing to take a long term position on the outcome of the cuts, one option is a CFD on three month sterling futures, known as “short sterling”. This represents the market’s future expectations of the change in UK base rates. It does not represent the current rate, it represents where traders think the interest rate will go next.

The short sterling spread bet or CFD is based on the expected interest rate subtracted from 100. The lower the price, the higher the market is expecting interest rates to move in the near future. If traders believe that UK interest rates are going to remain at the current rate, that price will remain static. However, should inflation continue to rise, the Bank of England will at some point be forced to raise rates.

Another way to take a view on the long term success of the cuts is a CFD on UK gilts. These would be directly affected as soon as the UK government was seen to wobble on its attitude to cuts. The problem with either approach is the high margins and the capital expense. An alternative is the IG Markets mini version of forwards and bonds contracts, offered at 20 per cent of the main contract size and margin requirement. Whichever route you may choose to take, with inflation currently soaring above interest rates, you have the incentive to seek investment profits just to stop your savings losing value.

“The markets” are unlikely to call a press conference or publish their memoirs at any point soon, but investors will voice their views more loudly than a London street full of protesters should the UK turn its back on spending cuts.