Thanks to everyone who read Get Yer Answers Here and asked questions. We’ve tried to answer everything and I hope what we’ve written will enlighten.

Questor asked what are Credit Spreads.
JM and PJF asked about the effect of Central Bank Intervention.
DW asked about discrepencies between the FTSE and the Dow.
DollarBabe asked whether the Dollar is the world’s most loved currency again or just a home for frightened money.
LaoGao asked about the impact of the FTSE falling beneath it’s 200day Moving Average.
BeanieBuzz and DK3 asked about whether we are heading for a full-scale recession and/or crash and whether a UK sub-prime crisis could also occur.

Yours,
Z and FT

Questor asks: What Does Credit Spreads Mean?

FT: Ah, credit spreads; they used to be my specialist subject in a previous existence.Think of the credit spread as the extra interest you receive for taking a risk. In bond land, which has suddenly become exciting, the safest bond you can hold is a UK Government Bond, referred to as a Gilt. Gilts have the highest credit rating of AAA and the rate of interest you receive is called the ‘risk free rate’.
So, you pop down to your local supermarket and buy a gilt offering a rate of interest of, say 5.25% a year. Not all that special, but you are certain to get your money back when it’s due.
But there are lots of other non-government bonds too, with a variety of ratings. And of the ones that have good ratings some warrant it. However others have it because they are so complicated they managed to confuse or persuade the credit rating agencies that they deserve it. The asset-backed securities that are making the headlines now fall into the latter category.
Because these non-government bonds are riskier and less liquid than gilts (you can’t trade them quite as easily or cheaply) they will offer a higher interest than gilts, say between 0.25-0.5%. The difference between the non-government bond and the government bond is your credit spread, but it’s quoted in pence. So the interest (or yield) would be 5.5-5.75% and the credit spread would be 25-50p.
In general terms the lower the credit rating, the higher the credit spread (you get paid more for taking a bigger risk with your money). With the movement in the market at the moment it’s hard to give exact examples but a couple will help you get the picture:

AA credit like HBOS 50-75p
A credit like Deutsche Telecom 100p
BBB credit like Safeways 100p+

In real life there’s far more variation than that; for example the longer the bond has to go before it’s repaid the greater its credit spread will be. But that’s it in a nutshell.

Z: The big issue at the moment is that people are getting risk-averse; they’d rather hold government bonds than bonds issued by companies. That means credit spreads are getting wider, which means:
a) companies have to pay more for their debt which hits their profits
b) companies that want to expand, either organically by building new factories or by acquiring competitors, have to pay higher interest rates.
Higher credit spreads would certainly not help economic growth and, if you combine them with a housing bubble in the US …. ouch!

By the way, if everything we’ve written here was pure gobbldygook you might want to brush-up on bonds: See Bond Spaghetti part i and part ii.

JM asks “If the central banks continue to pump money into the market is this likely to re assure investors or convince them that the situation is severe and cause further uncertainty? Considering the amount injected by the ECB in contrast to the US treasury are the ECB expecting rougher times ahead for European markets? And finally for how long can the ECB continue to inject money into the market?”.
On a similar note, PJF asks “What effect will Asian central banks continuing to put money into their markets? Especially if European ones are already looking like they are taking the back seat or taking money back out already.”

Z: JM and PJF, before I answer these questions bear with me while I give a quick description of the inter-bank market.
Banks are required to hold a certain amount of cash each and every night. However holding cash is a bit of a waste – who wants to hold cash when the money could be earning interest - so banks try to hold only just enough cash to meet their requirements.
However the amounts of cash banks hold go up and down every day, according to how much money they’ve made or lost. To get over this problem banks lend to each other. So if Bank A has had a good day and has excess cash and Bank B has had a stonker of a day and can’t quite meet its reserves, Bank A lends its excess cash to Bank B overnight. The interest varies according to supply and demand; the rates are known as the London Inter-Bank Offer Rate (LIBOR) and the European Inter-Bank Offer Rate (EURIBOR).
One feature of the inter-bank market is that the loans are not guaranteed. So if Bank A lends to Bank B and B goes bust, A loses the lent money.
What happened last week during the ‘credit crunch’ is that the banks stopped trusting each other – and started demanding ultra-high interest rates in order to lend to each other.
What’s more, LIBOR and EURIBOR rates are used in a lot of business transactions. If those rates had been allowed to stay high the pain would have been felt across the global economy.
So the central banks jumped in. They effectively said “we’ll lend to any bank that wants cash, and we’ll do it at x%.” That immediately brought the Libor and Euribor rate back down to x% and should have settled nerves. However the markets were somewhat shocked by how much money was demanded from the ECB – they started wondering whether the size of the ECB intervention was related to the size of the problem in the ECB’s mind.
The Fed also lent, although the amount they lent out was a lot smaller. Since then the central banks have been trying to lend less and less, although the Fed have been kept on their toes.
Central bank activity seems to have become a measure of how bad things are. Everyone has a different view of whether the central banks, and especially Trichet at the ECB have acted correctly. However to be fair all of them, whether from Asia, Europe or the Americas, have to walk a tightrope. They have to provide enough funds to make sure the banks can deal with any temporary problems while sending a ‘we have faith in the system’ message to the markets.
I’m not sure there is much – apart from policy differences – to be read into the fact that the ECB have put in a lot of funds, the Fed and some Asian central banks have put in a fair amount and the BOE have put in none. In short these are all very different institutions with different ways of handling things.
As for how long they can keep lending to banks – the answer is forever! None of these institutions are going to run out of money. However what they will be trying to do is get banks away from borrowing on an overnight basis an on to the more ‘ususal’ path of borrowing over the longer term.

DW asks: Why was the FTSE hit so bad on Friday when the Dow was almost unchanged.

Z: Hi DW. The FTSE is almost always affected by the direction of the US markets and that is especially true during troubled times like these. So I’m guessing that you are comparing the ‘official’ FTSE close (it closes at 4.30pm) with the official Dow close (it closes at 9pm our time). In the last couple of weeks we’ve seen some major drops in the last hour – sometimes the last 10 minutes – of trading. So comparing one close to another doesn’t really give the full picture.
One of the cool things about paddypowertrader is that it allows you to trade the FTSE even after 4.30pm – so if you compare the FTSE and Dow graphs on paddypowertrader you might not see that difference you were talking about.

DollarBabe says: OK Guys, so is the Dollar back to being the world’s most loved currency or just a home for frightened money? What should I be looking at?

FT:Dollarbabe, it does seem strange that the recent troubles began with widespread selling of the Dollar, due to the sub-prime problem, yet now each troubled headline seems to help the Dollar.
What I don’t know is whether traders are favouring the Dollar as a strong currency or simply closing off their existing trades, which are short of the Dollar.

At the moment it seems there are two camps:

Making risk trades
Buy equities,
Sell Dollar or Yen and buy Sterling, Kiwi, and Aussie.

Closing down risk trades
Sell equities
Sell Kiwi, Aussie, and Sterling and buy Dollar or Yen.

What should you be looking at?
The technical analyst in me would say, and I did in this morning’s blog, “watch the 200-day moving average on £$. So far it’s seen off some unwelcome attention, but a daily close below that could signal trouble.”
The realist in me would say, “watch the equity markets. As long as this panic continues it’s hard to see a Dollar sell off, but if things settle down watch for a test of the $2 level again.”

PS. I think the Yen is slightly more loved than the Dollar!

Z: I know nought about FX and should probably climb back into my box. However I suspect that there aren’t just short-term carry trades being closed but longer term equity, debt and commodity positions too. Let’s say an American fund managers had sold dollars to buy a foreign currency, then used that currency to buy an asset. To undo the trade they need to a) sell the asset and b) sell the foreign currency to buy dollars. Hence dollar has had some support. And the further the dollar rises the higher the valuation of the foreign assets and the more tempting it will be to sell these rather than US-based investments.
There’s a good article on Bloomberg.com about this too.

LaoGao says: The 2 big drops in the FTSE happened when the 20-day SMA approached first the 50-day and then the 200-day averages.
How big a drop will we see when the 50-day reaches the 200-day?
The only thing I’m doing in equities now is shorting.
Traditionally, the dollar will gain in these conditions. But the question is, are these traditional conditions (for FX), or are we looking at something special?

FT: There are times when I just have to hold my hands up and say, “Sorry, haven’t got a clue.”
I like to refer to the dark art of technical analysis for guidance, and often I find it extremely useful, but I don’t rely on it to provide all the answers. And the trouble with moving averages is that they reflect what has already happened.
What I mean by that is that by the time moving averages have crossed they’re only reflecting the price movement that has caused them to move anyway.
Granted, any crossover is taken as a change in trend direction and we might find that the 50-day, 100-day crossover is taken to signify a bear market, but I find more value in the shorter indicators.
For trading, I watch the 21-day moving average (MAV) and take a downturn in that as a warning signal. Otherwise I tend to use the 50,100 and especially the 200-day moving averages as price support/resistance. So I did took most notice, and turned bearish, when FTSE closed below the 200 MAV
How far does FTSE fall? Haven’t got a Scooby Doo. But it’s in danger of becoming more than the much needed correction.
In these times technical analysis, like fundamentals, are best only used as a guide. There’s a lot of fear and quite a lot of monkey business going on out there, so be careful.
On the currency question, see my answer to Dollar Babe above. I think this is a bit special, but it’s also traditional for the forex markets to have a run. Forex traders like nothing better than something like this; a trend to follow.

Z: LaoGao, you are probably sick of me saying this and you’ve probably gathered that I’m not a fan of technical analysis. But it’s worth repeating. If the 200day MAV is pierced then how far the FTSE will fall depends on what the factor is that caused the FTSE to drop so far in the first place.
Right now a position on the FTSE is a bet on:
a) how much money has been lost so far as a result of the sub-prime issue
b) how much money will be lost on sub-prime. This is in no small way dependant on what happens to the US housing market, and the US economy as a whole.
c) how frightened asset managers are of bad news hanging around in the pipeline
I don’t think there is anything a graph can tell us about any of these three questions.

BeanieBuzz says: US housing market really does look shagged, so I have two questions:
1) is that likely to trigger a recession in the US and if so what would be the best betting strategy?
2) as UK interest rates are higher that US ones is it likely that we’ll see our own sub-prime crisis?
Thanks lads, and love the columns.
DK3 asks: With continued volatility in the markets are we heading for a serious crash?

Z: Glad you like the columns BeanieBuzz. All compliments gratefully accepted.
So your first question: can a US housing market trigger a recession in the US? Possibly, but the problem would have to be a lot bigger than we are talking about at the moment.
The Financial Times had an article with some useful stats in it. Bernanke reckoned the fallout from the sub-prime crisis might be up to $100bn. That sounds like a lot of money but the FT reckons the total value of houses in the US is $20,000bn. I reckon that market could cope with a 0.5% fall in value.
What would be more worrying is if the US economy did go into recession, causing lots of people to lose their jobs and greatly increasing the number of mortgage defaults. If credit spreads stay wide that could do it. However indicators such as unemployment rates and corporate profits aren’t in any way suggesting a recession.
If the US economy does tank, led by a fall in consumer spendinng, it’ll be time to get shorting. Traditional plays would be to short housebuilders and anyone supplying white goods or credit (e.g. Mastercard). Mortgage companies will certainly also be hit – but is this issue already priced in? Another typical play would be to go long on defensive things like government bonds or companies that sell things people will need no matter what (e.g. Utility Companies).
Will we see a sub-prime crisis on this side of the pond? UK base interest rates are at 5.75%, about 0.5% higher than in the US, and are potentially still on the way up. Which could indicate the rate of mortgage defaults in the UK will be higher than in the US. On the other hand UK house prices haven’t given any major indication they are going to collapse. As long as people’s houses are worth more than their mortgages they have every incentive to keep paying – it’s when the house prices start falling and they get caught in the equity trap that giving the keys to the mortgage company and walking away becomes tempting.

FT: BeanieBuzz, the first bit is relatively easy. I don’t feel that the continued volatility in the markets signifies a crash. I think of volatility as a hurricane. Once in a while it comes along, and it’s a bit scarey. It certainly does some damage, but eventually it blows itself out.
This time around it’s a bit of a shock because of the scale of the daily moves. Also, the initial reaction to the sell off was, “Great, a buying opportunity.” Oops.
Market sentiment has now changed. Like all the best psychological thrillers the effect of recurring fear can’t be underestimated. Not quite another dead body, but the drip drip feed of sub-prime losses is refusing to go away and is increasing the fear factor. This spreading of fear, rather than volatility, could lead to a crash.
Will the US housing market trigger a US recession? If the top guys in the US don’t know I’ve got no chance, so let’s keep an open mind. At the moment most company earnings are looking OK and most economic data is looking fine (apart from housing related data). The trouble is that this data is historic and taken from the period prior to the recent crisis.
Cutting to the chase, the best betting strategy? Hmm, I’ve often found that getting the economics right doesn’t earn you very much because the strategy, though sensible, is often wrong. The typical response for a proper slowdown would be to sell equities, buy government bonds and sell the currency. If the slowdown causes interest rates to fall then bonds should benefit, because they pay a fixed rate of interest. But eventually good companies will become cheap enough to attract investors …
Similarly, strategists have a long history of getting currencies wrong. So all I’ll say is don’t get wedded to a view too early, watch the markets for what’s going on rather than looking for it to confirm your view.
Could we see a sub-prime crisis here in the UK? Tricky one. Why not? I’m not sure it would be the same as I’ve got no figures for those types of mortgages over here. But there must be risks to the buy-to-let market, and those quaint ‘self-assessment mortgages’ where customers were encouraged to think of a number and multiply it. Mervyn King wasn’t too worried, and he’s smarter than me, but there must be a risk.