Quarterly Outlook
Fixed Income Outlook: Bonds Hit Reset. A New Equilibrium Emerges
Althea Spinozzi
Head of Fixed Income Strategy
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Dampening equity sentiment could test GBP resilience
Charu Chanana
Chief Investment Strategist
Summary: GBP has been the best performing G10 currency so far in this quarter, but the resilience of sterling will be tested with much of the good news now priced in and wage pressures starting to top out. Sterling has shown close correlation to equity market sentiment lately, and any volatility spike can also bring risks to GBP strength. Speculator long positioning is also stretched, and technical indicators hint that GBPUSD may be close to over-bought territory.
Sterling has been the best performing G10 currency so far in Q1, as the outlook for the UK economy has shifted in a big way compared to 2023. Last year, UK economy faced a constant stagflation threat due to high services inflation and wage pressures but deteriorating economic activity. However, the economy is looking at a better 2024 which has given room to the Bank of England to delay its rate cut cycle. Markets expect BOE to cut rates in August, compared to Fed and ECB that are expected to start cutting rates in June.
On Friday, GBPUSD rose to fresh YTD highs of close to 1.29. A neutral UK budget and weaker US dollar has also been pushing sterling higher, but the rally is likely to be tested in the coming days and weeks. EURGBP tested the 0.85 support again on Friday before bouncing higher. We see the following as key tests in the weeks ahead for the GBP resilience to be maintained.
Bearish equity sentiment
As we have noted previously, GBPUSD is a compelling risk sentiment play. Our regression analysis between different FX pairs and MSCI All-Country World Index (MSCI ACWI) on a quarterly basis over the last two decades showed a high correlation for GBPUSD to the global stocks index.
Equity sentiment is starting to falter after strong gains in Magnificent 7 stocks since the start of the year. The big single stock story on Friday was the huge intraday move in Nvidia – the market darling – with the stock moving 11% from the high to the low. This is a very bad signal in terms of market health, given that Nvidia is a $2 trillion company. Key focus this week is whether the market will reverse, and volatility will pick up. If that was to happen, it could mean some safe-haven flows back to the dollar and other safe-havens such as JPY and CHF, and a hit to the risk sensitive currencies such as GBP.
The US CPI release today is also making markets jittery. Any risk of a hot February inflation will seriously question the disinflation trends, and potentially shift the Fed expectations in a hawkish manner.
BOE comments and UK wages
BoE policymaker Catherine Mann said on Monday that the UK has a long way to go for inflation pressures to be consistent with the central bank's 2% target. However this did not bring around strong gains in sterling on Monday as the expectation around delay in rate cuts is well priced in by markets. In fact, sterling was the worst performer in G10 FX space on Monday, possibly underpinned by a bearish equity sentiment.
Last month, BOE Governor Bailey said there had been “encouraging signs” on the key indicators in the jobs market and services prices, even as he stressed that policymakers are looking for evidence that progress can be sustained.
And the data out today on UK labor market data for the three months ending January showed that labor market is cooling, even as it remains tight by historical standards. Wage growth, excluding bonuses, came in softer than expected at 6.1% YoY (vs. 6.2% exp) in the three months to January. In the same period, Average Earnings growth, including bonuses, eased to 5.6% from the prior reading of 5.8% and expected growth of 5.7%.
The BOE noted at the last meeting that risks from domestic prices and wages were more evenly balanced. Its forecast is for inflation to fall temporarily to 2% in Q2 2024, before picking up in Q3 and Q4, and settling around 2.75% by the end of the year. These wage numbers could easily be a factor underpinning a dovish shift in BOE votes, where two of the members have been voting for a rate hike still at the last meeting. Economic growth concerns will also underpin, especially after the budget boost has remained minimal. UK unemployment rate increased to 3.9% in the three months to January, and consumer confidence slipped back in February, suggesting households are not ready to splash out. Next BOE meeting is on March 21, and February CPI will be released on March 20. Traders could wait for US CPI event risks before more seriously considering a bearish posturing for sterling.
Positioning and technical indicators
The recent COT report for the week ended 5 March 2024 showed that speculators opened 10,300 buy contracts and closed 1,700 short positions in GBP. As a result, the net position of non-commercial traders increased by 12,000 contracts in a week. The long position in GBP is now at its highest since August 2023.
Technical indicators are also signaling that sterling may be getting close to overbought territory. We use RSI and Bollinger Bands to show short-term overbought conditions in the charts below, which could signal near-term, pullback in case of a data miss, especially given the lack of follow-through on Friday’s break to fresh YTD highs.
The first key support for GBPUSD is at the 1.28 handle, following which strong support is seen at 21DMA at 1.2680. GBP has gained the most against the JPY and CHF year-to-date, followed by AUD. If BOJ pivot expectations continue to grow, GBPJPY could test 100DMA around 186. Likewise, GBPAUD risks slippage towards 100DMA around 1.9150.
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