G10 FX Weekly: GBP and UK Short-End Yields to Fall in Tandem

Summary

• Market pricing for additional Bank of England (BoE) rate hikes in H2 2023 and early 2024 is very aggressive.
• With economic data, especially housing and employment metrics, starting to look shaky, the BoE may deliver less tightening than markets are pricing.
• As a result, we like scaling into a long position in the UK short end.

Market Implications

• Bullish 2-year Gilts as the yield nears its cycle peak – it traded at a ~15-year high last week above 5.5%, with market expectations of additional BoE rate rises driving UK yields higher. We think outright yield levels in the UK short end are attractive and therefore like scaling into a long 2-yr Gilt position. Because so much is priced in, we like this exposure from a risk/reward perspective.
• Bearish GBP as lower UK yields will weigh on the currency – sharply rising UK yields have driven sterling resilience this year. The favourable yield differentials that have led GBP higher will dissipate if UK yields fall as we expect. We therefore stay bearish on sterling.

Introduction

Recent price action in UK interest rate markets has been relentlessly bearish, as the BoE hiked rates more aggressively than expected last month. This prompted rates traders to ramp up expectations for additional aggressive hikes in coming months.

Currently, the UK 2-year yield is very near the top compared with other G10 markets, and the additional tightening priced into the UK short end (should it happen) would take the BoE’s policy rate above all its developed market peers.

In the UK, however, economic data is starting to look worrying. In the housing market, prices are falling the fastest since the GFC in 2007-2008. Employment data is also softening, pointing to a slowdown.

Given how important housing is to the UK economy, we suspect this may restrain the BoE. There is an awful lot of additional tightening priced into the UK curve, after what has already been an aggressive hiking cycle.

We think the BoE will deliver less tightening than markets are pricing.

Therefore, as we have argued in other G10 markets (including the US, Germany, Australia and New Zealand), UK short-end yields are now at attractive levels. As in those markets, we like a patient approach, scaling into a long position in the UK short end.

We think the 2-year gilts yield can initially trade back to June’s 4% handle in the coming months. Markets may have overpriced BoE tightening, so we expect a correction.

If we are correct, we also expect lower UK yields to exert downward pressure on GBP. Sterling has benefitted recently from aggressive BoE pricing.

The combination of the BoE delivering less tightening, the UK economy slowing, and recession risks rising will be negative for the currency.

We have previously argued for playing GBP from the short side. These potential new gilt market dynamics increase our conviction.

Market Pricing of BoE Expectations Is Hyper Aggressive

The past six weeks have seen UK yields rise sharply – driven by ramped-up expectations for aggressive, additional BoE tightening.

On 1 June, the 2-year Gilt yield closed at ~4.29%, with markets pricing the BoE terminal rate to hit ~5.35% at yearend. The first cut was expected by May next year.

Fast forward to now, and the 2-year Gilt yield is at 5.43%, with the market pricing a yearend rate of 6.20% and terminal rate of ~6.30% in March next year.

On 22 June, the BoE surprised markets by hiking 50bp, when traders had priced only ~34bp the day before. This aggressive policy move, following higher-than-expected headline and core inflation prints the day before, increased expectations of more aggressive tightening.

This saw the 2-year Gilt yield peak last week on an intraday basis at 5.56%, about 13bp above the current level.

Assertive BoE Actions Constitute Front-Loading of Tightening

After the outsized rate hike last month, Macro Hive’s Henry Occleston argued compellingly that the BoE’s 50bp hike ‘…constituted a front-loading in hiking…’ and that the central bank ‘…is hoping that by September the data will allow them to slow or stop the hiking cycle.’

There is now currently a strong probability of another 50bp hike priced for the next BoE rate decision on 3 August, which I argue is consistent with front-loading.

With another 100bps of tightening priced beyond the 50bps next month, the market has already priced a lot. We see room for this hyper-aggressive pricing to moderate and UK short-end yields to drift lower, especially if inflation starts softening as BoE Governor Andrew Bailey expects. Bailey this week said that he expects inflation to fall ‘markedly’ in the coming months.

If our front-loading thesis and Bailey’s inflation prognosis are correct, the BoE could easily pause (or materially decelerate) rate hikes. Either way, this will probably fall short of current market pricing.

This scenario opens material downside for 2-year gilt yields, given how much is already priced into the curve.

Housing Data Looks Worrying

The housing market and rising mortgage rates are front-page news in the UK. Bloomberg News even described them as a ‘national obsession.’ And recent housing market metrics are certainly cause for concern given the market’s importance to the British economy.

Recent survey data from mortgage lender Halifax showed UK house prices are falling at their fastest annual pace since 2011. Higher mortgage rates, with many common fixed-rate loans now above 6%, are squeezing affordability.

Another house price index, compiled by the Nationwide Building Society, showed a 3.5% decline on the year – the most since 2009 (Chart 1).

Worryingly, according to BoE Governor Bailey, the full impact of enacted rate increases has yet to hit the UK economy. When this happens, the already shaky housing market may become even more fragile.

Further deterioration in the housing market will weigh on the economy. As households feel poorer, spending will probably recede, slowing growth and probably tipping the UK into recession.

Indeed, the inverted 2-year/10-year UK yield curve points to a high probability of a recession in Britain (more on this below).

If inflation slows as Bailey expects, and the UK falls into recession, we think the BoE will be considerably less aggressive than the market currently prices.

Employment Data Mixed but Slowing

This week’s UK employment data also points to a potential domestic economic slowdown.

On the surface, the jobs report was mixed – with both hawkish and dovish implications for the BoE.

On the hawkish side, wage growth remained strong, with average weekly earnings rising (both including and excluding bonuses). This ties in with the narrative of too-high UK inflation and cemented the market expectations of a 50bp hike next month.

On the dovish side, as my colleague Henry Occleston pointed out, the net conclusion is that the data showed a softening UK labour market.

Henry highlighted declining full-time employment and rising unemployment as evidence of loosening job market. Moreover, Henry argues that the labour market loosening ‘…will dominate the tone ahead for the BoE if it continues (surveys suggest it will).’

The combination of a faltering housing market and a cooling labour market will be a headwind for UK inflation and economic growth.

The BoE has already tightened monetary policy materially. And with another 50bp hike fully priced for next month, the central bank will probably hike less than the market currently expects over the next nine months or so.

As such, we favour scaling into to a long 2-year Gilt position. The yield is at an attractive level. And with so much already priced into the market, a pullback in UK short-end yields is likely.

Scale Into a Long 2-Year Gilt Position

The 2-year UK yield has only gone one way since the year-to-date (YTD) trough in March, with yields up over 240bp since then. About one year ago, that yield was ~1.7%, versus the current ~5.4%.

The BoE, of course, has undertaken an aggressive and concerted tightening cycle through this period, culminating in a 50bp hike last month and another rate rise of the same magnitude expected next month.

Nonetheless, we think that the 2-year yield is at or near its cycle peak.

The reasoning, as outlined, is that markets are pricing so much into the UK short end.

And given the expectation of further aggressive BoE tightening into next year, we think there is now a market asymmetry. The risk/reward favours fading elevated UK short-end yields.

A cooling labour market and a fragile housing market point to an economic slowdown emerging. If BoE Governor Bailey is to be believed, inflation is set to moderate considerably, with the impact of the BoE’s already material tightening yet to hit the UK economy.

These dynamics give us the conviction to expect lower short-end yields in the UK.

Additionally, an inverted UK yield curve is probably foreshadowing a recession in the next year or so.

Using the 2s10s curve shape, Macro Hive’s US recession model assigns a 92% probability of a recession in the next 12 months. The US 2s10s calendar spread is deeply inverted, currently at -90bp, not far from the recent multi-decade extreme.

The UK 2s10s calendar spread is similar at -77bp, also near a multi-decade inversion extreme.

With a confluence of macro indicators in the UK – the housing and jobs markets, together with an inverted yield curve – we expect material downside in the UK 2-year yield. We therefore like cautiously scaling into a long 2-year gilt position.

GBP Will Slide With Lower UK Yields

The Deutsche Bank GBP trade weighted index (TWI) currently trades very near a ~15-month high.

We think a great deal of GBP strength this year is due to the aggressive expectations of additional BoE policy tightening.

Over the past six weeks or so, UK yields and the pound have risen concurrently. The 2-year Gilt yield is 100bp higher since the close of business on 31 May, while the GBP TWI is up ~2% over the same period.

On a YTD basis, the same picture emerges. The UK 2-year yield is 185bp higher this year, while the GBP TWI is up 5.35% in 2023.

Should we be correct about the 2-year UK yield falling, our intuition is very simple. Lower UK yields will also weigh on sterling.

We have been fighting the GBP rally throughout this year. Nonetheless, we think the turn in UK yields will also herald a lower GBP.

Richard Jones is a Macro Strategist for VDK Capital, a London-based venture capital firm. He has traded and invested in interest rate and FX market portfolios spanning three decades, both on the buy-side and sell-side. 

Photo Credit: depositphotos.com

(The commentary contained in the above article does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs.)