The Governor of the Bank of England, Mark Carney, has validated the view that UK interest rates may rise earlier than previously expected. In a speech yesterday, Mr. Carney stated that “[a rise in interest rates] could happen sooner than markets currently expect” implying that the consensus forecast for the first rise in interest rates expected to happen in March of 2015 is wrong. Solely based upon Mr. Carney’s statement, the new thinking is that interest rates will rise before the end of 2014 and consequently the world’s central banks will keep their eye on their UK counterparts for an example of how to exit extremely low or zero bound interest rates. Already the UK rates curve and Pound Sterling are reacting to this proclamation and it seems likely that both assets have further room to run in the months ahead.
Notwithstanding Mr. Carney’s new stance on rates, like all other central banks employing non-traditional monetary policy, the BoE will remain data-dependent. In the same speech Mr. Carney went on to say that any interest rate increase would be very gradual and that the speed of the rise was more important than the timing of the rise. Shock us… dial it back… try to make it hurt less… In sum, rates in the UK are very likely to rise either towards the end of this year or early next year and that’s big news.
The precise reason that Mr. Carney made his pronouncement on rates is unknown. A possible reason has to do with the UK labor market and rate of unemployment which has fallen to 6.6% at the most recent reading. That unemployment rate is far below 7.0% rate that the BoE previously held out as a threshold for higher interest rates when they were operating under the policy of “forward guidance.” Like the Federal Reserve, the BoE has dropped forward guidance in favor of a more qualitative approach to rates and now focuses on traditional econometrics such as inflation readings, GDP growth and slack in the labor force. What is clear, is that the UK economy has been on an upward trend.
Add to this upswing in economic data, a serious paranoia about recent increases in South East England home prices. Home prices are rising in London at an annualized 17% rate which is a huge number in the abstract. Part of that inflated rate is the effect of the Middle Eastern, Russian and African oligarchs buying into the preferred international city of the world. Real estate in London, is expensive. Still, it is hard to imagine the Bank of England raising interest rates for the singular purpose of helping home buyers in Bethnal Green, Southwark and Bermondsey avoid speculative pricing. The broader sense of protecting against asset bubbles is sensible because there is a risk that a housing crash in London could bring the entire UK to its knees. A housing crash in London is not likely to happen absent a simultaneous housing crash in New York, Tokyo, Paris, etc. The BoE knows this and is reacting to the broader sense of the risk.
Now that Governor Carney has provided this new guidance, the issue of whether UK government bonds (“Gilts”) sell off will be front and center. Up and until this point, the long end of the Gilts curve has fought the consensus view that rates will rise in 2014 and been bought by risk adverse credit market participants for many of the same reasons that US Treasuries have been purchased: microeconomic data, global geopolitical risk, BoE policy and technical issues, and most importantly, relative value. The spread between “riskless” 10 year German Bunds and Gilts might make for a nice trade especially if levered and funded with cheap currencies from elsewhere. That spread between Gilts and Bunds currently stands at 134 basis points whereas the spread between 10 year US Treasuries and Bunds is 121 basis points.
The front end of the Gilts curve is where the effect of rising rates will be most felt. For example, the day after Governor Carney’s speech (Friday, June 13th), 2 year Gilts were up 17% in yield terms. Leveraged rates and credit market participants with little margin or tight risk limits will continue to get stopped out and leave traders bloodied. Since the beginning of the year, 2 year Gilts are up 45% in yield terms. The fact that the front end of the curve is selling off faster than the back end of the curve should not be surprising. In the near term, it is likely that the UK rates curve will continue to flatten and holding a small long position in the front end of the curve probably makes some sense.
At the longer end of the curve, the 10 year UK Gilt may have put in the lows of the year in yield terms assuming geopolitical events do not materially devolve and the ECB’s recent monetary policy announcements are implemented apace. Shorting 10 year UK Gilts should be viewed as a trend trade (longer term) rather than a trade with tight stop losses. Some market participants are paring their short 10 year Gilts with Long German 10 year Bunds. At a yield of 1.36%, the risk with this pair trade is more on the Bund side than with the Gilts. Conversely, some market participants may take the recent upward moves at the front end of UK Gilts and the flattening of the curve as an opportunity to enter into a short term risk reversal type of pair trade between long 2 year Gilts and short 2 year US Treasury bonds, especially in light of the upcoming FOMC statement, forecast and press conference. The central idea of this trade is that a short term snapback on UK Gilts may be forthcoming and that the US Fed may employ more a hawkish tone than expected. Lastly, the British Pound Sterling is on an upward trend and this is likely to continue for the near term. A popular trade may be to short the EUR/GBP cross as a way to gain exposure to higher UK rates and lower economic and rates expectations for the Eurozone.
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