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Summary
- In the two-year maturity, the spread of UK yields over Eurozone yields has widened in recent weeks.
- We think hawkish BoE pricing has gone too far, as has dovish ECB pricing.
- A repricing could see spreads narrow and support our bullish EUR/GBP view.
Market Implications
- We would fade any widening of the Eurozone/UK short-end yield spread.
- We like scaling into a cross-market spread trade, receiving the UK 2-year swap vs paying the Eurozone 2-year swap. This week could provide attractive entry points.
ECB Offered Nothing New Last Week …
As we argued in our ECB reaction piece on Monday, the ECB offered nothing new in its messaging from last week’s rate decision.
During the press conference, ECB President Christine Lagarde referred to her comments the week before in Davos, where she highlighted the likelihood of the first ECB rate cut coming in the summer.
There was, therefore, no additional guidance from Lagarde on the ECB rate path.
… Yet Short-End Yields Are Materially Lower
The market seemed to be hoping for a stronger pushback on rate cuts. As a result, short-end Eurozone yields have dropped sharply since the rate decision last week, with the 2-year EUR swap rate down 10bps.
Chart 1: Orange line = 2-Year Euro Swap Yield
Put another way, we do not think the fall in yields was triggered by anything dovish in the ECB statement or in the Lagarde press conference.
The dovish market reaction was such that a 25bp rate cut in April is now fully priced, versus only a 64% probability before the ECB meeting.
UK Short-End Yields Have Climbed This Month …
By contrast, UK short-end yields have risen sharply this month.
Using the 3-month, December 2024 Sonia futures contract as a proxy for BoE rate expectations, prices have fallen (and implied yields have risen) by 50bps since the close on 29 December.
Chart 2: Orange line = December 2024 3-month Sonia Futures Price
On 29 December, there were 30bps of easing priced for the BoE meeting in May. The pricing has more than halved, with only 14bps currently priced.
… But We Expect Tomorrow’s BoE Outturn to Be Dovish
The BoE’s Monetary Policy Committee (MPC) meets tomorrow and will update its economic forecasts in its Monetary Policy Review (MPR).
We expect the MPC to tilt in a dovish direction in the MPR. Wage expectations and inflation will need downward revision from the previous forecasts in November given recent data misses.
BoE Governor Andrew Bailey will struggle to push back against market pricing when inflation looks likely to touch 2.0% before the summer.
Additionally, although we expect the MPC to hold rates steady tomorrow, we see a very good chance fewer hawkish dissenters call for an immediate rate rise (as they did recently), adding to the decision’s dovish tone.
Eurozone/UK 2-Year Swap Spread Has Room to Tighten
The combination of recent dovish ECB and hawkish BoE market pricing has taken the spread in Eurozone/UK short-end rate spreads to levels we think are worth fading.
Chart 3: Orange line = 2Y EUR/GBP yield differential
We think that the market will reverse the recent trend of overly dovish ECB and overly hawkish BoE expectations.
This week’s Eurozone inflation print could provide a good entry point to fade spread widening. The data will be very volatile, but our lean is towards a lower reading versus expectation.
Narrowing Rates Spread Will Support EUR/GBP
The narrowing of short-end rate spreads between the Eurozone and the UK should also support higher EUR/GBP.
As we argued last week, widening rate spreads (initially driven by too-hawkish BoE pricing and heightened by dovish ECB pricing) have weighed on EUR/GBP.
If, as we expect, these yield differentials narrow, EUR/GBP should trade higher.
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.