G10 FX Weekly: Preparing for UK Short End to Outperform

Summary

• G10 FX and rates markets are chopping around within ranges as investors await a busy September for developed market central banks.
• We expect the rangebound performances of July and August to hold in coming weeks.

Market Implications

• We expect short-end yields in the US, Germany and the UK to trade lower once activity picks up next month.
• We favour the UK, though we expect yields to fall across these three markets.
• The market has priced in too much additional Bank of England (BoE) tightening, increasing the potential for yields to fall when the BoE tightens less than expected.

Introduction

As with developed currency markets, the short ends of G10 rates markets have been rangebound this month. We expect this to continue in coming weeks.

The US Federal Reserve (Fed), European Central Bank (ECB) and BoE all tightened policy in the past few weeks. Investors are now playing a waiting game until their next rate decisions in September.

We like to reduce position sizes until then because of the time of year and the market conditions. August is the height of the summer lull in the northern hemisphere and, as such, liquidity will be at a premium, and already volatile markets could be even more illiquid and choppy.

Nonetheless, our bias remains for lower short-end yields in the US, Eurozone and UK. As such, we continue to favour fading any yield increases towards the top of the July/August ranges.

Given how much further BoE tightening is now priced into the curve, our favoured long position is in the UK short end.

What Is Priced for the Fed, ECB, and BoE?

The Fed, ECB and BoE have all tightened monetary policy aggressively over the past 15-18 months.

While market pricing suggests all three central banks have almost finished hiking, nuanced and important differences exist between what the market expects for each policymaking body.

Fed Pricing is Already Very Dovish

Ahead of the Fed’s next rate decision on 20 September, market pricing has tilted very dovishly. In coming months, expectations for further Fed rate hikes are extremely low.

The market prices only a tiny probability (~12%) of the Fed hiking 25 basis points (bp) when they meet next month. Without a September hike, the probability rises to roughly 40% for a hike on the following meeting on 1 November. And with neither a September nor November hike, it recedes to about a third for the final meeting of 2023 on 13 December.

In 2024, the market starts to lean towards Fed easing, with the first Fed 25bp rate cut priced roughly by mid-year.

The market is saying that the Fed has almost certainly finished hiking.

ECB Pricing Sees One More Hike by Year-End

The market also sees the ECB approaching the end of its tightening cycle, but expectations are less dovish than for the Fed.

For the next meeting on 14 September, there is a ~50% probability of the ECB hiking by 25bp. If the ECB does not hike in September, the probability rises to ~82% for the 26 October meeting, where expectations peak.

Therefore, the market assigns a high probability of another 25bps rate hike by year-end, but it expects the ECB to skip the September meeting.

BoE Pricing Is More Hawkish Than Its Peers

Of the three central banks, market expectations for the BoE are the most hawkish.

A 25bp hike is fully priced for 21 September, with the market now pricing a ~62% probability of a 50bp hike (~31bp priced).

If the BoE hikes 25bp next month, the market fully expects the central bank to deliver another 25bp on 2 November.

Beyond this, the market sees the BoE Terminal Rate peaking at ~6% in February next year, which would imply another 75bp of hikes from now.

A Quick Look at UK Data This Week

Amid quiet markets, UK data stood out this week – both the employment numbers on Tuesday and inflation data yesterday.

UK Short-End Yields Lurched Hawkishly

The market reaction to this data has been acute.

At the close of business yesterday, the 2-year gilt yield had risen 17bp since last week’s close, taking the yield to its highest closing level since 14 July.

Similarly, market expectations for the September BoE meeting tilted decisively hawkishly this week. At the close of business yesterday, the market priced in 31bp of expected tightening next month, versus 21bp of expected tightening at last week’s close.

The Data Was Less Hawkish Than the Market Reaction

My colleague Henry Occleston examined both the employment and inflation data, arguing it does not support the hawkish reaction.

For the employment data, Henry noted that the market’s hawkish reaction was based on the jump in year-on-year wage growth in June, which was an eye-catching 8.2%.

The details are far less hawkish, though. The jump in wages was driven by public sector wage growth, which is less important to the BoE as it does not present a cost pressure to firms.

Moreover, the unemployment rate, driven by a decline in employment, shows that the UK labour market is loosening far faster than the BoE had expected. Full-time employment dropped sharply again, and the shift in employment composition will weigh on future wage growth.

For the inflation data, while the headline reading plummeted to 6.8% from 7.9% last month, the decline was less sharp than consensus expectations.

Additionally, the core CPI reading remained at 6.9%, despite the expectation that it would drop marginally to 6.8%. Rises in rent prices drove the core inflation stickiness.

This will not surprise the BoE and therefore not prompt increased hawkishness, since, as Henry noted, the data roughly aligns with BoE estimates.

And while services inflation exceeds the BoE’s estimate, Henry highlighted that inflation momentum in wage-intensive services is fading. This should lower the need for more BoE tightening.

This week’s market reaction, therefore, is overdone, providing an opportunity to fade the price action.

UK Short-End to Outperform the US and Germany

With more policy tightening priced into the UK short end than in the US and Eurozone, we think a long 2-year gilt position is attractive.

We think corresponding US and German yields also have downside, and we could fade the recent rise in those 2-year yields. But the UK stands out as our favourite.

US 2-Year

The US 2-yr yield has traded in a 4.61-5.12% range since 1 July, currently just under 5%. We expect this range to hold for the next few weeks and for the yield to drop into year-end, beginning next month.

We have liked buying on price dips in the US short end for several months. And the reason is simple.

Outright yield levels in the US short end are attractive. A 2-year yield at 5% is relatively high and will tempt buyers, especially given the yield curve inversion. Currently, investors are not required to assume duration risk to get an attractive yield. The US 2-year yield is 70bp higher than the US 10-year yield.

This curve inversion is important, as well, as it is a robust predictor of a potential recession in the US.

Despite the increasingly prevalent Goldilocks/soft landing narratives for the US economy, the Macro Hive recession model assigns an 88% probability of a recession in the next 12 months.

With the inverted curve pointing to an elevated probability of a US recession, fading a rise in US short-end yields is attractive.

True, there is scope for hawkish data surprises given market pricing is already so dovish. But as we head into the Fed rate decision next month, we still favour US short end yields to trade lower.

Germany 2-Year

The German 2-yr yield has traded in a 2.88-3.35% range since 1 July, currently at ~3.09%. This range should cap price action through the rest of this month, with the yield set to drop from there.

As with the US, we have found the outright levels of German short end yields attractive – the 2-year yield above 3% is relatively high and will tempt buyers.

The German 2s10s curve, as in the US, is also inverted, pointing to a heightened probability of recession. This is also the case in France, the Eurozone’s second-largest economy.

The outright yield level, in addition to curve shape, therefore, makes fading the recent rise in German short end yields attractive.

UK 2-Year

The UK 2-year yield has traded in a 4.83-5.56% range since 1 July and is currently trading at ~5.2%. After this week’s hawkish price action, fading the rise in UK short end yields is particularly compelling.

The above reasons for fading the US and German yield rises also apply to the UK.

The outright yield, currently at 5.2%, is attractive by itself. Plus, the UK’s inverted 2s10s yield curve, and the elevated recession probability associated with it, makes fading the recent rise in yields even more compelling.

However, the most convincing reason for fading the UK short end yield rise is because of the market’s hawkish BoE expectations.

These expectations have ratcheted higher over the past couple of days, despite the details of this week’s data being less hawkish than the market reaction suggests.

With pricing as stretched, going long the UK short end is our favourite trade in the G10 rates space.

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. 

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(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.)