In Aggressive And Defensive Equity Bets we looked at how the how the economic cycle affected different sectors; a slowing economy saw banks, builders and Marks & Sparks suffering whilst utilities, tobaccos and Wal-Mart out-performed. When the economy turns up this flips into reverse. So, so by co-ordinating the long / short directions of your trades with whatever phase in the economic cycle we happen to be in we can help tilt the odds just a tiny bit more into our favour.

One of the massive pluses of spread betting is that we’re not limited to trading shares; the investment world is our oyster and the little pearls we can bet on include bonds, gold and oil for starters; then there’re different currency trades to reflect risk, commodity strength and relative slowdowns. And that’s what we’re going to look at this week.

First though, you need to think of investment markets as Dwain Chambers (without the drugs), whereas the economic cycle is more Sonia O’Sullivan. Or put another way, by the time we recognise where in the economic cycle we are, most investments have already been there, got the T-shirt and moved on.

As a quick rule of thumb bonds and gold are defensive plays (i.e. more likely to do well in a downturn), oil is an aggressive and currencies, well, currencies are just there to be traded.

Good In Defence? Depends What The Attack’s Like
Apart from sticking the money under your old gran’s mattress bonds are about as defensive as you can get. When you buy a bond you know what you’re going to get back in interest (dividend) every year until the bond matures (and you know in advance the exact amount and date of the final repayment at maturity).

Spread bets are only available in bonds guaranteed by top-rated governments like the US, UK and Germany. These governments haven’t been kind enough to extend the guarantee to the spread bet, but it still means you’re betting on something that ain’t going bust.

There’s another reason that Government bonds do well in an economic slowdown too; not only do they continue to pay the same amount of interest each year, but they also benefit from falling interest rates (falling yields equals higher prices). And central banks usually (but not always, and not at the moment in Europe) drop interest rates in a downturn in order to get people borrowing and spending again.

But, but BUT there’s a catch. This doesn’t work so well when inflation is rising. Rising prices make a bond’s future fixed payments worth less. If you really want to read up on the inner secrets of bonds and how they work check out the two links below:
Bond Spaghetti Part 1
Bond Spaghetti Part 2

By the way, like oil and gold the spread bet is on the futures contract in bonds rather than an individual bond. These futures typically represent a 10-year bond, although the US and Germany offer 5-year alternatives; the US, of course, has to go one better and offer a 30-year as well.

So How Have Bonds Done During This Slowdown?
Check out the chart below, supplied by Bloomberg. Because gilt futures contracts are quarterly it’s tricky to get a sensible history of the prices. But this chart shows a real gilt that closely matches the gilt contract. Contrast the fairly relaxed 7% rise, followed by the equally unbothered 7% fall, with the 20% fall in the FTSE since last July. At first the price rose as investors sold their corporate bonds into the safer government bonds. The rise continued as traders reckoned the central banks would have to cut interest rates to bail out the banks. But this year bond prices fell back as the inflation monster loomed large.

A final note on bonds; the less time they have to maturity (final repayment) the more volatile they are. So, for example, the US 30-year should make you more (or lose you more) than the 10-year version. If you’re running in a new pacemaker, and need to keep excitement to a minimum, the 5-year spread bets should do the trick (failing that get a season ticket to watch Chelsea play).

Commodities-Aggressive Or Defensive?
Gold and oil are traditionally very different plays. Gold, like bonds, is a classic defensive play. Oil, on the other hand, has been seen as an aggressive trade. Rising oil prices was thought to rely on a rise in US and European manufacturing and transport driving demand ever higher.

However over the past few years the edges have become a little blurred. Manufacturing in much of the developed world has been overtaken by the service sector, which is less exposed to changes in the oil price. Emerging nations like China and India have picked up the manufacturing baton. So, whilst the Western economies have been crunching close to recession, demand for oil has been rising in other parts of the world. Also, recent performance has been influenced by the weak Dollar and rising inflation, which gave commodities an extra kicker.

Gold in particular is considered a great safe haven from inflation, financial risk, geo-political risk and most other risky things you can think of. It’s a real asset, solid, heavy and shiny. There’s constant demand for it (worldwide, not just in Essex), which mostly exceeds supply. It isn’t destroyed by war, fraud, bank failures or inflation, and importantly there’s no chance, a la sub-prime, of people not understanding what they’re buying. Hence gold has done well during this downturn.

Oil has been a great hedge against inflation, but that’s a bit like saying that staying drunk is a great hedge against hangovers. Energy prices have been largely responsible for recent inflation woes so it makes sense that buying the main culprit is a good hedge. Oil also acts as a safe haven investment in times of geopolitical unrest. But this has more to do with fears of disruption to supply and is related to the countries involved. If Spain suddenly took a strong dislike to Portugal I don’t think it would rank too highly on the oil Richter scale. But if a game of Middle-East Scrabble descends into disagreement the world rushes for the nearest petrol station.

If you’re new to commodities check out these beginners’ guides:
How To Trade Oil. The Cruder Way
A Crock Of Gold

Forex
The simple rule when it comes to the main FX pairs is sell whichever economy looks weaker and buy whichever looks stronger.

Now the biggest, butchest most aggressive forex play is the US Dollar; so if the US economy is tanking and the Eurozone is OK (like for much of the past 8 months) then the smart move is to sell the Dollar and buy the Euro. However accepted wisdom (by some) is that whatever happens to the US will travel across the Atlantic and hit the Eurozone 12 months later. So if you think the US looks to be bottoming out but Europe is tanking (as some have started to suggest in the last couple of months) it’s worth having a look at selling Euros and buying the Dollar.

Over the past few months there’s been loads of comment about the low-yielding Yen benefiting from ‘flight to safety’ money. The implication was that your money was guarded 24/7 by samurai warriors, beating back the evils of the crunchy credit crises.

Check out almost any Yen chart. I’ve shown the popular SterlingYen (GBPJPY) chart below, but DollarYen (USDJPY) or EuroYen (EURJPY) tell the same story. Because the exchange rate against most countries is so high, even small percentage moves give adrenaline junkies wet dreams.

In my humble opinion the Aussie and Canadian currencies are another way of playing commodity prices, as their economies are dependant on the demand for gold and oil.

What About Now?
First off, don’t take any of the above as a trading strategy; it’s just a few more ingredients to add to the overall trading casserole. It’s handy to have a background idea of what should happen, but still use your charts and news flow to drive the day to day trading decisions.

As I said in Aggressive And Defensive Bets (Part 1)-Equities, the economic picture is still very cloudy. In many countries it’s almost a weekly coin-toss as to whether the central bank will raise interest rates to combat inflation or cut them to stimulate growth. Consequently there are few, if any, strong currency trends at the moment. Equally, bonds are a low volatility bet, but an uncertain interest rate background makes them a tough one to call.

Gold and oil have a last shown a token correction, but it’s hard to bet against either of them in the longer term. The big question is where to set a buying target. Of the two I’d be seriously tempted to buy gold at around the $880-90 level. That’s where it meets and greets its 200-day moving average.

The trouble is that although this is a great support level there’s still enough scope to loose your Johnny Vegas sized shirt before the trade rights itself. So I’d look to step-aside on the way down and look to hitch a ride once it’s back in the up-elevator.

I’m off to visit some new beaches for a couple of weeks. However be sure to keep an eye on this blog. Rumour has it paddypowertrader have some very hot talent ready to keep this blog cookin’.