Macro: Sandcastle economics
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UK labor data and Huw Pill's comments are not enough for a bond bull rally
Althea Spinozzi
Head of Fixed Income Strategy
Summary:
- UK Market Activity: Wage growth exceeded expectations and the unemployment rate increased to 4.3% in April. The Bank of England’s chief economist suggested potential rate cuts this summer, although significant progress on wage growth is still needed.
- Gilt Yield Dynamics: Gilt yields have dropped across the yield curve as investors anticipate rate cuts. However, extending duration may be risky as long-term rates could continue to rise if the BOE cannot meet rate cut expectations due to reaccelerating inflation or economic growth.
- Investment Strategy Considerations: Short-term yields provide a safer option for parking cash, with 2-year yields at 4.31% being less susceptible to losses compared to long-term maturities. Investment-grade corporate bonds in Sterling, offering a premium over Gilts, may also be a prudent choice while awaiting clearer macroeconomic conditions.
It was a busy morning for the UK markets today. Wage growth exceeded expectations, while the unemployment rate increased from 4.2% in March to 4.3% in April. Additionally, the Bank of England’s chief economist, Huw Pill, indicated that rate cuts might be considered this summer, although there is still progress to be made on wage growth.
The OIS swap market currently indicates a 60% chance of a rate cut in June and anticipates at least two rate cuts by the end of the year. It is important to note that market expectations have shifted significantly since the beginning of the year, when seven BOE rate cuts were being priced in. Expectations are likely to evolve further, especially if improvements in inflation or wage growth stall.
As investors anticipate the Bank of England's rate-cutting cycle, we have seen Gilt yields dropping across the yield curve. However, is it wise to extend duration to secure 4.15% on 10-year Gilts and 4.64% on 30-year Gilts, which are among the highest yields since the Global Financial Crisis?
To answer this question, it’s important to understand why the BOE is rushing to cut rates despite wages and inflation remaining above the central bank’s target. Although policymakers are advocating for a soft landing, the reality is that interest rate cuts and dovish rhetoric are predominantly from central banks in overleveraged countries such as Sweden and Japan. These central banks prefer currency depreciation over enduring economic pain due to their fragilities.
The problem arises if central banks cannot meet their rate cut expectations because of reaccelerating inflation or economic growth. In such a scenario, the anticipated bond bull market may not materialize. The reason is simple: rate cuts ease financial conditions, potentially leading to better growth and higher inflation in the future. This implies that while short-term rates may fall following central bank actions, long-term rates could continue to rise. A bond bull rally will only form if a significant economic breakdown occurs.
Looking at long-term Gilts with maturities of more than ten years, they have dropped 5.5% year-to-date. Thirty-year Gilt yields have risen from 4% at the beginning of the year to 4.65%, while 10-year Gilt yields have increased from 3.45% to 4.16% and remain in an uptrend.
While short-term yields have also dropped considerably, they provide a more favorable option for parking cash and awaiting opportunities. It's important to note that the BOE’s own forecasts indicate the possibility of inflation rebounding after hitting 2%, suggesting that we might not see another rate cut after the one widely anticipated this summer. This scenario would leave Gilts vulnerable.
With 2-year yields at 4.31%, assuming a six month holding period, they would need to rise above 6.14% before incurring a loss, making them a less directional bet compared to long-term maturities. Additionally, investment-grade corporate bonds in Sterling, offering a premium over Gilts, could be a good place to wait and see how the macroeconomic backdrop unfolds.
In summary, focusing on short-term yields and investment-grade corporate bonds may be a prudent strategy while navigating the current uncertain economic environment.
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