Senior Fixed Income Strategist
Summary: The Bank of England is trapped. Following this morning's CPI numbers, it may need to hike to levels that might be uncomfortable for the financial sector. The front part of the yield curve is poised to rise towards 5% as swap spreads revert to their mean, but as yields approach this level, chaos might ensue, forcing the BOE to step in to save the day. We are monitoring the 2-year Gilt yields, which, if they break above 4.68%, will find resistance at 5.57%, a level not seen since June 2008. As 2-year yields test the 4.68% level, the BOE will ring the alarm bells and try to cap their upside. Within this uncertain environment, we prefer to keep duration at a minimum.
The Bank of England has a big problem.
The central bank missed its inflation target since 2021, and according to its estimates, which assume a constant interest rate of 4.5%, it will only be able to bring it back to the target in the last quarter of 2024.
Those estimates need revision. The road towards 2% looks to be bumpier than the BOE forecasted. Today’s UK CPI numbers showed that the UK core CPI rose to 6.8% YoY in April, the largest increase on record, while it was estimated to come at 6.2%. The monthly headline inflation figures came at 1.2%, almost double what was forecasted, which, if annualized, would bring inflation to 14.4% YoY.
When assessing monetary policy, it helps to acknowledge that the BOE is mandated to protect price and financial stability. That differs from the Fed's dual mandate, which requires the central bank to maintain stable prices while seeking to foster growth and maximize US employment.
Therefore, the BOE must continue tightening the economy until its chief goal to meet the 2% inflation target is met despite advancing unemployment.
The UK Gilt yield curve is much less inverted than the US yield curve.
The reason behind such a difference is that markets believe that the Fed has finished tightening, and since March, investors have started to position for a pause. A much flatter yield curve in the UK indicates that the BOE's tightening job is not over yet.
Two-year Gilt yields will continue to rise but will unlikely break above 5%
From this morning, markets are pricing three full rate hikes this year and are close to forecasting even a fourth hike bringing the forecasted terminal rate to 5.50%.
Together with quantitative tightening, rate hikes should help swap spreads to tighten back to their mean.
The prospect of a much higher terminal rate brings my focus to the front part of the Gilt yield curve, which will likely remain under pressure in the following months.
In particular, I like to look at the 2-year Gilt yields, which have broken above resistance at 4.20% this morning, and they find their next resistance is at 4.67%, a level that was last seen in September in the aftermath of the Truss' mini-budget. With the terminal rate now expected at 5.25%, it's easy to envision the 2-year rise towards this level.
However, the BOE has a problem with it. The sudden surge in gilt yields last September ignited a series of events that forced the central bank to step in and buy long-dated gilts to tame volatility. That series of events concerned pension funds, which saw margin calls in their interest-rate swap positions triggered as yields surged, but they didn't find enough collateral to post.
The same is likely to happen also this time, and the BOE should be concerned that this moment is approaching because if 2-year Gilt yields break above the 4.68% level, they'll find resistance next at 5.57%, a level last seen in June 2008. Following the events of last fall, it is clear that the financial system cannot take rates that high yet; hence, it is safe to assume that the central bank will not allow rates beyond 5% and step in to cool off the sell-off earlier than that.
For the same reasons, the BOE will be on alert if 10-year Gilt yields test 4.59%.
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