Dancing around the problem

In financial markets, very often the question is "who's next?". We saw that with the banks in 2008 and, most recently, with the peripherals in Europe. The obvious candidate here is the UK.

Sentiment on the UK is generally pretty poor, not without reason, and short GBP was one of the big consensus trades of 2009 (with repeated head-scratching from many punters when January 2009 proved to be the low - note, never listen to Jim Rogers!). Spot traders need little encouragement to sell Sterling, as "bashing Betty" is one of their favourite pastimes. Gold priced in Sterling looks well on its way to hitting the 1000-mark, following the USD and EUR both hitting that "prestigious" level. Good job Gordon.


And since the election, Gilts have started to cheapen vs. SONIA (green line), but as seen with the GDP-weighted average EMU spread (vs. EONIA, orange line), they can potentially widen a lot further. It is also interesting that USTs (vs. OIS, white line) and Bunds (vs. EONIA, pink line) have not materially moved, the latter is somewhat surprising given that the Germans are going to pick up the tab for all those Greek swimming pools. Indeed, the Greeks seem to have misunderstood what the market meant when it said that Europe needed its very own TARP programme (http://wealth.net/2010/05/greek-tax-avoidance-101-cover-your-swimming-pool-with-a-tarp-fool-a-satellite/).

But apart from that, markets appear to have become cautiously optimistic on the Con-Lib coalition, but a lot of the so far announced policies are not really what you would want to hear from a government that is supposedly Centre-Right and supposedly cutting the deficit. In order to get the LibDems on board, Cameron had to agree to a £17bn tax cut for the cider-drinking-socks-and-sandals-beardie-weirdie brigade from the Southwest, agree to hike Capital Gains tax to as much as 50% ('cos that's gonna reverse the brain-drain to Singapore/Switzerland and attract foreign companies to list on the LSE...), and give control of banking reform to Vince "I predicted everything" (oh no you didn't) Cable. For those not familiar with this Class A crackpot, he spent the last few years verboten repeating everything he read in The Economist, achieving a somewhat-Delphic reputation in the UK media. Oh yeah, and he wants to cap bank bonuses at £2500. And his expertise is Development Economics - i.e. building wells and schools in Africa. Hardly the kind of experience required of someone who is intending to restructure the financial system. Cable is definitely a short. So is Sterling.

Speaking of Development Economics, today we got a taste of fiscal consolidation UK-style, with the Times reporting that the DfID (The Department for International Development) has announced that it is to cancel a £146,000 project for "a Brazilian-style dance troupe with percussion in Hackney". Err... not sure that's going to help, guys.

The currently announced fiscal policies amount to a £10bn fiscal ease. (Shouldn't the UK be cutting its deficit, not increasing it?!) The IMF reckons removing VAT exemptions would go 3.5% of the way to the 9% they think is needed to stabilise the UK's debt-GDP ratio, and hiking VAT to 20% should provide another 1%. But removing the VAT exemptions (such as children's clothes) is probably not going to go down well with the LibDems who are essentially an un-reconstituted socialist party. And VAT needed to go up anyway, even without enacting a stimulus. The numbers just don't add up. Unless they get significantly more credible by the June 22nd Emergency Budget, the UK is going to get Fitch-slapped.

The government, as all incoming governments do, has accused the Labour Party of a "scorched-Earth policy" of leaving several of Brown's turds around Whitehall in the form of unpublished spending commitments. And Liam Byrne, Labour's outgoing Chief Secretary to the Treasury is reported to have written a note to his successor that reads "Dear Chief Secretary, I'm afraid to tell you there's no money left". Well, I guess at least he's honest... While this is obvious politicking, it all seems a bit deja vu to last October and the restatement of Greece's budget deficit.

Some of Brown's potential turds:

• Private Finance Initiatives (Broon's off-balance sheet accounting trick) - £139bn.


• The un-funded public sector pension liability (Broon's great Baby-boomer giveaway) - £1,104bn.


• Contingent liabilities - e.g. Network Rail (so privatisation didn't work after all, huh?) - £22bn.


• Financial sector interventions (Broon saving the world and Fred Goodwin's pension) - £130bn.

...which comes to a startling total of £1395bn + the official debt number (£890bn), a grand total of £2,285bn or 162% of GDP. Perhaps it's a bit unfair to include the pension liability (which most Western countries have) or the financial sector interventions (which, provided RBS hasn't done its cods on European bonds as well as everything else, will probably post a profit one day), but the others are fair game. That comes to 96% of GDP and could potentially be announced as part of "opening up the books" and discovering Brown couldn't add up all. Beware of Scotsmen bearing Red Briefcases...?

Merv' the Swerve keeps a'swervin', being about as dovish as he possibly could at last week's Inflation Report. Osborne talks about tighter fiscal policy meaning rates will be lower for longer. That's a textbook "sell the currency" scenario. But does the market actually already price in this tightening? So the logic goes, as the government increases its share of the economy, it forces up the Real Exchange Rate as the government spends money on domestic "stuff" and employs more people (thereby pushing up the relative prices and relative wages). And the flip-side, is that as it reduces its share of the economy, it removes demand for those goods and the associated job cuts push down unit labour costs, weakening the Real Exchange Rate. The below chart shows UK General Government Consumption (white line) vs. the BoE's Effective Exchange Rate (brown/green series). Obviously the banking sector interventions have artificially pushed up the Government's share of the economy, but even excluding those, it looks as though the currency is already anticipating a sharp fiscal contraction.

But facts aside, the Cable chart doesn't look particularly bullish, and until there is clarity on the Budget, bashing Betty looks like a good strategy...