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Summary
- The UK 2-year yield hovers near last week’s six-month high.
- The Bank of England (BoE) Monetary Policy Review (MPR), following last week’s 25bps cut, broadly aligned with our expectations, without overly hawkish messaging.
- However, hawkish Fed pricing is feeding into BoE pricing, which challenges fading elevated UK short-end yields.
Market Implications
- Despite the risks, we like cautiously fading elevated UK short-end yields, by scaling into a long position.
- Currently, the market only prices two 25bps cuts over the next year, which we think underestimates what the BoE will deliver, especially given the November MPR Bank Rate projections.
Despite BoE Easing and Messaging, UK Yields Remain Elevated
The BoE cut 25bps last week, with the Bank Rate now at 4.75%.
With this outcome widely expected, the 2-year gilt yield has remained near last week’s six-month high (Chart 1).
The 2-year gilt yield also currently trades just below the resistance zone at ~4.55% to ~4.70%, where the yield topped out earlier this year.
OBR Budget Analysis Spooks Gilt Market
Selling in US rates has driven the rise in UK long-end yields since mid-October. However, the 30 October UK budget exacerbated the move, prompting a jump in UK yields.
My colleague Henry Occleston described the gilt market reaction as a ‘bloodbath,’ with the selloff lifting the UK 2-year yield ~20bps and the 10-year yield ~15bps over the last two days of October. November has seen further bearish price action.
While the market was ‘rightly spooked’ by the increased trajectory for DMO issuance, we argued
the deficit picture could be better than it initially appears as the investment spend will probably be lower than the OBR forecasts.
The key was how the BoE reacted to the budget.
BoE Market Pricing Is More Hawkish Than the MPR
Last week’s BoE messaging was not overly hawkish despite the market’s anxiety about the UK budget. The BoE stressed the uncertainty of the effect but did not expect it to change the near-term policy path. This aligns with our expectations, and we think the meeting
‘opens the way to more dovish BoE pricing.’
Despite this, the market is now only pricing two 25bps BoE cuts in the next 12 months.
This market pricing is more hawkish than the most recent MPR projections for monetary policy (Chart 2).
Even BoE hawks are talking of gradual cuts. We think gradual cuts reasonably imply one cut per quarter.
This means room exists for the market to price more easing, which will weigh on short-end UK yields.
Hawkish US Price Action Is Feeding Into UK Rates Market
Since the end of September, the US 2-year and 10-year yields are up roughly 65bps and 70bps, respectively.
This hawkish price action has fed into the gilt market.
In the short end, which is the most sensitive part of the curve to monetary policy, the correlation between the US and UK markets is now at a post-GFC extreme (Chart 3).
While the continuation of this bearish US/UK correlation is a risk to our bullish gilt trade idea, it is reasonable to conclude that, should this dynamic normalise, UK short-end market pricing will gravitate towards dovish BoE expectations, as outlined in this month’s MPR.
However, given the volatility and stop/start nature of gilts’ price action, we like to scale into a long position in the UK 2-year. This requires patience but is the most prudent way to enter the position.