G10 FX Weekly: More Downside for UK Short-End Yields, Bearish GBP/CAD

Summary

• The 2-year UK gilt yield has fallen over 30bps from last month’s peak.
• This followed the dovish policy update from the Bank of England (BoE)’s Monetary Policy Committee (MPC) last month, voting 7-2 in favour of holding rates. Two dissenters (including Deputy Governor Dave Ramsden) called for an immediate cut.
• The BoE updates policy next week during the UK election campaign, in which the MPC operates a self-imposed purdah.

Market Implications

• We think the recent downward momentum for UK short-end yields can continue and reiterate our initial target of 4% outlined last month.
• We think lower UK short-end yields will weaken the pound, and we express this view via GBP/CAD.

After Dovish BoE Tilt in May, MPC Declares Election Purdah

As outlined in our piece on 10 May, the MPC’s messaging was dovish despite the BoE keeping rates unchanged.

The vote count first indicated this dovish shift. Then came BoE Governor Andrew Bailey’s comments on market pricing: saying ‘it’s likely that we will need to cut bank rate over the coming quarters … possibly more so than currently priced into market rates.’

The BoE has had a self-imposed purdah since the 22 May announcement. Next week’s policy update will be the central bank’s first communications since then.

UK Data Since the Last BoE Update

The most closely watched UK release during the past few weeks was the employment data.

Breaking down the data this week, Macro Hive’s Henry Occleston said broad evidence still suggests slowing employment growth and loosening labour market conditions.

And, while private regular pay growth remains above BoE expectations, the gap narrowed in April.

Moreover, across services sectors, data suggests frontloading of minimum-wage rises in accommodation and catering, but less in retail.

Henry contends the BoE should take comfort consumer-facing services pay growth still trails business services.

This should reassure the MPC that policy tightness is feeding through – although not enough to justify cutting next week.

Nonetheless, the jobs data indicates to us that the BoE will cut more than the market is pricing this year.

UK Short-End Has Been Choppy, But Yields Now Trending Lower

Chart 1: 2-Year UK Gilt Yield = Orange Line

Since expressing our bullish view on 10 May, the yield has bounced within a 25-30bps range.

Our bullish call last month was slightly early.

Additionally, there may be room for an upside correction as UK short-end yields have fallen sharply since the top in late May.

However, a durable trend has emerged over the past two to three weeks, and we think the UK short-end is now a buy-on-(price)-dips.

Given Henry’s view on the recent data, following the BoE’s dovish shift last month, we expect more MPC dovishness next week.

This will weigh on UK short-end yields.

Further US Short-End Yield Drop Could Drag UK Yields Lower

This year, the direction in US yields has strongly influenced the direction of UK yields.

The two-way price action in US yields is also evident in UK yields.

Choppy price action has characterised the UK short end over the past month or two, making trading difficult.

Chart 2: 2-Year US Treasury Yield = Orange Line

It is therefore encouraging for UK gilt bulls to see US yields tumbling so far this month.

In June, the 2-year US yield has fallen roughly 20bps and is about 30bps lower than in the last week of May.

This week’s price action has been telling, with weak data points more than offsetting the slight hawkish 2024 shift in the Federal Reserve’s dot plot.

We expect the lower US yields trend to continue. This will also feed into the UK short end.

Lower UK Yields Will Weigh on GBP

If UK yields fall further as we expect, GBP should also trade lower.

Our favoured pair to express this is GBP/CAD.

GBP/CAD at Multi-Year High

GBP/CAD is trading at its strongest level since 2021. At this extreme within the ~15 big figure range, present since the pandemic began in 2020, fading GBP strength is attractive from a technical, mean-reversion perspective.

Chart 3: GBP/CAD Spot Price = Orange Line

In a piece earlier this week, Macro Hive’s Ben Ford outlined four key reasons why GBP/CAD is likely to trade lower.

• GBP/CAD long positioning is crowded and due an unwind.
• Two-year rate differentials in favour of GBP are stretched and due an unwind.
• Positive data surprises in the UK are unsustainable.
• The oil market could tighten in coming months, which will be CAD positive.

For these reasons, we think GBP/CAD will trade lower from the current level.

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Richard Jones writes about FX and rates markets for Macro Hive. He has traded and invested in interest rate and FX market portfolios spanning three decades, both on the buy-side and sell-side.

(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.)