Rates and FX are waking up to a less hawkish Bank of England reality

We're expecting the Bank of England to hike in May and June, but the tone is turning more cautious. The BoE's voting pattern and lower growth forecast should be hints that hike expectations at the front-end of the curve are excessive. As the central bank hits the pause button in the summer, we expect markets to wake up to the less hawkish reality.

After months of being at the forefront of the core rates market sell off, with a clear underperformance in H2 2021 relative to US Treasuries and German Bund when the BoE ramped up its hawkish message, gilts are now warning that the sell off is running out of steam. A string of weak sentiment data had the market re-rate recession probabilities, and gave weight to the comparatively cautious tone adopted by the BoE.

Breaking 2% to the upside remains a possibility for 10Y gilts but we expect them to continue to lag Bund and USTs if bond selling resumes. We foresee yields ending 2022 at 1.8% and the rally should accelerate next year. We also caution that impaired liquidity conditions in the gilt market make outright selling by the BoE less likely in the near term.

The UK is far from being the only economy with a worrying growth trajectory, and we should eventually see German Bund and US Treasuries catch up to the gilt rally. Our best guess is that will happen in the third quarter this year once the Fed has a few hikes under its belt and once inflation has stabilised. It is however noteworthy that, after being ahead of the pack when it came to tightening, it now looks as if the BoE has the luxury to adopt a more prudent approach when inflicting more policy tightening to its domestic economy.

We have been warning for months that the policy rate path implied by GBP swaps looked too aggressive, but that a turaround was only likely once the BoE tightening cycle is well underway.

The gilt curve should re-steepen helped by deflating rate hike expectations

Hike expectations have now started to come off, but we think this is only the beginning of the adjustment lower. This has started a race between front and back end rates. We think curve dynamics will depend on when global yields peak. If we’re right in seeing a few more months of global bond sell-off, then the gilt curve should re-steepen during the same period, also helped by deflating rate hike expectations.

Sterling has had a bad week at the office. The Bank of England's broad trade-weighted measure of the pound has sold off 2% over the last week as a combination of: a) weak UK consumer data and b) a much tougher risk environment on the pincer movement of higher US real rates and weaker Chinese growth prospects. Incidentally, GBP/USD has had one of the highest G10 FX correlations with global equities over the last few months.

Sterling has had a bad week at the office

In looking at the various EUR/GBP reactions to the four BoE scenarios outlined above, we have used our Financial Fair Value (FFV) model as a guide. This identifies key drivers of EUR/GBP pricing such as yield differentials, the shape of the UK yield curve and the equity environment as inputs. The problem is those yield differentials have lost some of their explanatory power recently. In fact, one has to go back to earlier in 2021 when say a 5bp move in the GBP:EUR yield two-year differential was worth about a 1% move in EUR/GBP.

Assuming that the beta on the yield differential driver is lower, we present more conservative EUR/GBP levels in our scenario analysis above. Our baseline scenario sees some modest GBP weakness - e.g. EUR/GBP to 0.8450 on the BoE event risk. But James Smith has been making his case that the BoE Bank Rate will end the year at 1.25% as opposed to the 2.15% currently priced by the market. If and when that penny drops, GBP could take another large leg lower and GBP/USD may end up far closer to the 1.20 level than we had originally forecast.