Rates and FX are waking up to a less hawkish Bank of England reality
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Markets are expecting the Bank of England to be a lot tougher and are slowly waking up to a less frightening reality. This means that gilts will struggle to follow Treasuries and yields of the Bund will be higher, and should the curve push up in price. Sterling has begun to react to weak consumer data and, except for one very surprising surprise, risks appear to be skewed to the downside.
We are expecting a hike in the Bank of England in May and June, but the tone is becoming more cautious. The BoE’s voting pattern and low growth forecast should be an indication that growth expectations are high at the front end of the curve. As central banks hit the pause button in the summer, we expect markets to wake up to a less frightening reality.
gilt canary in coal mine
After leading months of major rate market sell-offs, with a clear underperformance in the second half of 2021 relative to the US Treasury and the German Bund, Gilts is now warning when the BoE pushed its bullish message That sell-off is running out of steam. A string of weak sentiment data showed bearish prospects in the market and gave weight to the comparatively cautious tone adopted by the BoE.
A breakout of 2% upwards remains a possibility for the 10Y Gilts, but we expect them to continue trailing the Bund and UST if bond selling resumes. We expect the yield to end at 1.8% by 2022 and the rally should pick up next year. We also caution that poor liquidity conditions in the gilt market reduce the chances of an outright sale by the BoE in the near term.
Gilt spreads reflect deteriorating economic outlook in dams and treasuries
Refinitiv, ing
The UK is far from being the only economy with a worrying growth trajectory, and we should finally see the German Bund and US Treasury catch up to the gilt rally. Our best guess is that the Federal Reserve will have some hikes under its belt in the third quarter of this year once inflation stabilizes. It is noteworthy, however, that, having been ahead of the pack in terms of tightening, it now appears that the BoE has the luxury of taking a more prudent approach while further tightening policy on its domestic economy.
Gilt Curve should rise again as expectations rise
Refinitiv, ing
We have been warning for months that the policy rate path implied by the GBP swap looked too aggressive, but that a turnaround was likely only if the BoE’s tightening cycle is well underway.
Growth expectations are now starting to ease, but we think this adjustment is just beginning to ease. This has started a race between front and back end rates. We think the dynamics of the curve will depend on when global yields peak. If we are correct in seeing a few more months of global bond sell-offs, the gilt curve should stabilize again during the same period, as well as help dampen expectations of rate hikes.
Our four scenarios for the May BoE meeting and expected market reactions
FX: Waiting for Penny to Drop
Sterling is having a bad week at the office. The Bank of England’s broader trade-weighted measure of the pound has sold 2% in the past week due to a combination of weak consumer data from the UK and a very tough risk environment on the pinner movement of higher US real rates and weak Chinese growth prospects. , Incidentally, GBP/USD has had one of the highest G10 FX correlations with global equities over the past few months.
Looking at the different EUR/GBP responses to the four BoE scenarios outlined above, we have used our financial fair value ((FFV)) model as a guide. It identifies key drivers of EUR/GBP pricing such as the yield gap, the shape of the UK yield curve, and the equity environment as inputs. The problem is that the yield gap has recently lost some of its explanatory power. In fact, one has to first go back to 2021 when say a 5bp move in GBP/EUR yield was about a 1% move in EUR/GBP over a two-year gap.
Lack of growth expectations mean GBP could take a leg down
Refinitiv, ing
Assuming that the beta on the yield differential driver is low, we present a more conservative EUR/GBP level in our scenario analysis above. Our baseline scenario sees some minor GBP weakness, for example, EUR/GBP to 0.8450 on BoE event risk. But James Smith has been taking the stand that the BoE bank rate will end the year at 1.25%, compared to 2.15% currently priced by the market. If and when that money falls, GBP could take another big leg down and GBP/USD could end up much closer to the 1.20 level than our original forecast.
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