G10 FX Weekly: BoE Outlook Exposes UK Yields and GBP to More Downside

Summary

• Last week, the Bank of England (BoE) hiked rates for a 14^th straight time, raising its key policy rate (Bank Rate) from 5% to 5.25%.
• Despite this, the 2-year gilt yield fell ~8 basis points (bp) last week, and the Deutsche Bank GBP Trade Weighted Index (TWI) also fell by ~0.75%.
• We expect UK short-end yields and the pound to fall further in coming months.

Market Implications

• Bullish UK Short End – On 13 July, we correctly anticipated the decline in the UK 2-year gilt yield. We expect the move to continue, with plenty of downside from the current ~5% to the year-to-date (YTD) intraday low of ~3% (our eventual, longer-term target).
• Bearish GBP TWI – We also anticipated GBP TWI depreciation on 13 July and now see further downside. We think the trade-weighted pound can revisit its YTD trough (about 4.75% lower from here) in H2 2023.
• Bearish GBP/CHF – GBP/CHF is down ~1.7% since we published our bearish call for the pair on 1 June. In coming months, GBP/CHF can trade near the all-time closing low seen last September, near 1.06.

Introduction

The BoE hiked 25bp last week, matching the US Federal Reserve (Fed) and European Central Bank (ECB) the week before. Despite this policy tightening, UK short-end yields and the trade-weighted pound both ended the week lower than before the announcement.

Driving these moves has been market pricing of BoE expectations, which is decidedly more dovish than about a month ago. Even with some of the peak hawkishness now priced out of BoE expectations, we expect a further dovish unwind. This will drag UK yields and sterling materially lower.

BoE Messaging Was Dovish

Most of the BoE’s Monetary Policy Committee (MPC) voted for a 25bp hike last week. Six MPC members voted for the move, two for a 50bp increase, and one for a pause.

Market pricing after the BoE rate decision and press conference tilted more dovishly (more on this below), and my colleague Henry Occleston’s assessment of the BoE’s messaging was consistent with this market reaction.

Henry argued that the Monetary Policy Review (MPR) forecasts were dovish and sees continued room for more dovish surprises.

The details from the latest MPR were more downbeat than the previous report in May. CPI expectations for this year and next were lowered, the path for unemployment was shifted higher, and the net trajectory of the GDP forecasts for 2023-2025 was lower.

This led Henry to conclude that ‘the underlying data is supporting [the BoE] hiking less than priced.’

Hawkish BoE Market Expectations Have Moderated

If market pricing is any guide, traders came to the same conclusion as Henry.

The week of 10 July, when we last wrote about UK yields and the pound, the market saw the Bank Rate at ~6.25% by year-end, peaking at ~6.4% in Q1 next year.

After the rate decision last week, the market sees Bank Rate at ~5.65% by year-end, peaking at ~5.75% in Q1 next year.

For the next meeting on 21 September, market pricing assigns an ~84% probability of a 25bp hike, with Bank Rate currently priced at ~5.39% on that date.

On 2 August, the eve of the BoE’s rate decision last week, the market was pricing Bank Rate at ~5.49% for 21 September. The market has therefore removed a big chunk of the expected tightening that was priced in recently.

If Henry is right, however, we think the market could still price out additional BoE hawkishness.

Softer Survey and Hard Data Has Been a Key Driver

Key UK data (both survey and hard) had softened between the BoE rate decision in June and last week’s hike.

The June inflation print of 19 July drove the market’s dovish repricing. This data came in softer than expected across the board, with year-on-year headline CPI printing at a 15-month low. UK yields and the pound declined sharply in response.

Another driver we have previously highlighted was the deteriorating housing market. Housing metrics have been softening in recent months, and this trend continued with data released this week.

Both Halifax and the Nationwide Building Society, two big UK mortgage lenders, have reported falling UK house prices. Halifax said house prices fell for a fourth straight month in July, while Nationwide said last week that house prices fell 3.8% from a year earlier — the most since 2009.

Beyond housing, the British Retail Consortium (BRC) and KPMG reported a steep annual drop in the volume of retail sales, citing higher interest rates as a key driver.

In addition to households being squeezed, the Institute of Directors (IoD), one of the UK’s main industry lobby groups, said that BoE rate hikes are hurting UK businesses. The IoD said there is ‘…quite a lot of downward pressure on prices coming through now’, adding that UK rates may peak ‘lower than the market is expecting.’

Fed and ECB Expectations Matter, Too

As with BoE expectations, US and Eurozone expectations have also seen a dovish repricing.

This is important. Like the BoE, both the Fed and the ECB have been battling inflation.

For the Fed, market pricing gives a high probability of the Fed’s hiking cycle already being completed. The market currently prices only a 12% probability of a 25bp hike at the next meeting on 20 September. For the following meeting on 1 November, that probability is only 22%.

For the ECB, expectations are slightly more hawkish but muted compared with this time last month. The market prices a 36% probability of a 25bp hike for the 14 September meeting and 61% for the 26 October meeting.

If expectations for the Fed and ECB become more dovish, it will exert additional pressure, beyond domestic considerations, on BoE expectations to follow suit.

UK Yields to Fall Further, Dragging GBP With Them

We think the 2-year gilt yield and GBP TWI can keep falling in H2. The former’s 2023 peak was on 6 July, while the latter’s YTD high printed on 11 July.

UK Short-End Yields

The week of 10 July, when we last wrote about UK rates and GBP, the 2-year gilt yield was at 5.44%, having peaked the week before at 5.56%. Back then, we called for a lower 2-year gilt yield, and it has since fallen to ~5% (Chart 1). We expect more downside.

The fall in the 2-year gilt yield in recent weeks has, of course, been driven by the more dovish BoE pricing.

Given Henry’s dovish BoE prognosis, together with the softening survey and hard data, we expect further pricing out of BoE tightening.

This will feed into the UK short-end and should see the 2-year gilt yield tumble further.

GBP Trade Weighted Index

Since the week of 10 July, when it peaked YTD, the GBP TWI is down about 1.1%. We think that on a trade-weighted basis, the pound can trade back to its 2023 low seen in early March. That is about 4.75% lower than now.

The reasoning is simple. As BoE pricing continues its dovish trend, lower UK yields will weigh on the pound.

Throughout the year, we have argued that periods of GBP outperformance in 2023 have been driven largely by aggressive expectations of BoE tightening.

Those expectations have started to unwind, and the pound has traded lower. Expect more of the same in coming months.

We Like GBP/CHF Lower

Beyond the GBP TWI, our favourite currency pair through which to play GBP weakness is against the Swiss franc (CHF). We like short GBP/CHF.

The franc is the strongest G10 currency YTD, and we expect this broad CHF strength to continue into H2 2023.

We published a bearish GBP/CHF view on 1 June, as part of a wider bearish GBP outlook. The pair has since fallen about 1.7%.

We expect this to continue thanks to a more dovish BoE, leading to lower UK yields, combined with ongoing CHF resilience. That should see the pair trade down toward the record low (on a closing basis) seen last September, near 1.06.

My colleague Ben Ford wrote on 28 July that the franc was due a downward retracement versus the euro. Ben viewed this potential move as a correction.

Should the EUR/CHF correction occur (the pair has tracked sideways since Ben’s piece was published), CHF weakness may feed into GBP/CHF. We would view this prospective move as corrective and a selling opportunity for GBP/CHF.

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.)