Bank of England governor Mervyn King: bullish inflation report last week

Rally continues without much ado

Equity markets staged yet another impressive week of buying, and in the process of doing so they made new yearly highs. The Dow Jones briefly moved above 10,300 last Wednesday evening, a level not seen since September 2008.

This was more than 2% higher than the previous week's close, and a massive 6% from the month's low.

This strength came in spite of the fact that there was a relative scarcity of important economic or company specific news during the week.

Traders continue to buy into the momentum, but the size of positions and balance between long and short is shifting.

On the Chicago Mercantile Exchange there are now more contracts short on the S&P 500 than there are long, but the amount of both long and shorts has reduced. The move up since March has thus far been a fairly smooth ride, and at present there is little to suggest that the next few weeks will be any different.

In December it will be interesting to see if investors sell their positions and book profits.

It will also be interesting to note the balance between long and shorts towards the end of the month.

Next year we are expecting a pull-back in equity prices, as companies struggle to meet heightened valuations, and economic conditions remain hostile. But this does not mean that we won't be trying to eke more money out of the long side here. Traders should not over burden themselves with concerns on the economy, but should instead search for insight into where the money is flowing. The market is not a reflection of current economic conditions, and they are rarely a reflection of future economic conditions, it is instead a much more complicated and schizophrenic beast than many realise. After all, most economists make money selling books, and not very often from trading the markets. The only really significant piece of economic news last week came in the Bank of England inflation report delivered by governor Mervyn King.

The report was relatively bullish on the economy, predicting a return to growth at the beginning of next year, accelerating to 3.75% by mid 2011. King also talked about the positive effect that a weak sterling was having on economy and did not rule out the possibility of further quantitative easing.

The report also predicted that inflation would remain slightly below target over the next two years. The reaction to these comments in the currency markets was swift. GBP/USD fell from $1.675 to $1.665, and EUR/GBP rallied to £0.902.

The report was seen as a strong indication that the bank would not be raising rates any time soon.

The realisation that the bank would not reject the idea of further quantitative easing also weighed on sterling's price, but the bank won't mind that at all. They have been using every platform they can to express their desire for a weak currency.

Oil prices on the up

The oil market also traded in a tight range last week.

From Monday to Wednesday the range tightened to approximately $2 between $80/bbl and $78/bbl. Fortunately though this tight range has still provided traders with plenty of opportunities to make money as both ends of this range were reached on these days.

With Veterans Day on Wednesday the weekly oil inventories were pushed out to Thursday and as usual these figures provided much volatility in the market. In fact it looked as if the figures were leaked a few minutes beforehand as the market fell sharply prior to release of the numbers. The figures showed yet another build in Oil supply and this pushed the market below $77/bbl for the first time in the week. At the time of writing the US light crude was still trading around $77/bbl.

Finally what has been very interesting this week is the disconnect between the Oil market and Equity markets. In the past few months the correlation between the two markets has been very strong but for the past two weeks this correlation has dissipated.

Last week, for example, the Dow Jones was up 2% while oil was down 0.8% at the time of writing. Despite this I still feel the future direction of equities will play an important role in the direction of oil. If, for example, equities continue to push higher and oil can get through the $81/bbl level mentioned earlier this month, it will make a very sharp move toward $85.

On the flipside if the equities markets find a "top" without the oil market getting significantly beyond $81, then if the equity markets fall, oil prices should fall at an accelerated rate.

Written by Paddy Haran & Vinay Sharma, traders at Delta Index