Thoughts on the BoE, the Fed and rates

The evolution of the market backdrop continues to support the argument for higher yields, particularly in the US and although the Euroland PMI disappointed, Q2 growth still seems on track to tick up from Q1. Meanwhile, two international factors which could driver yields higher, improving sentiment towards China and a better outlook for Japan, have received a boost with the latest manufacturing PMI data, whilst the US existing home sales data have supported the view that the slowdown in the US housing data is over for now.
Against this backcloth, the prospect of central bank policy divergence remains in focus. Last week’s FOMC statement and SEP delivered on all of the more hawkish aspects of the pre-meeting expectations for better growth language, lower unemployment rate forecasts, and an upward drift to the 2015-16 dots but Mrs Yellen called the evidence of a rise in inflation “noisy,” and struck a relatively dovish tone despite acknowledging the high degree of uncertainty a number of times.
The Fed’s dismissal of inflation, in particular focus given the 0.3% core CPI reading, which, unrounded, was the highest since October 2009, has paved the way for the market to price in some renewed inflation risk premia. The notion of the Fed potentially falling behind the curve on inflation has gained traction, as evidenced by the performance in TIPS breakevens and markets anticipate that there’s a risk of an overshoot of inflation in the near term, without conceding that there is at present much risk of structurally higher inflation over the long term of ten plus years.
Meanwhile the dynamic relationship between the US and UK policy agenda and rates markets continues to evolve. The re-pricing of hike expectations that followed Mr Carney’s Mansion House speech suggests that the UK is expected to be further along in its hiking cycle than the US in one year’s time, although inflation expectations in the US have picked-up relative the UK. Equally, the US continues to diverge with Europe, with both hike and inflation expectations supportive of a growing spread between US and European yields.
For the UK, Mr Carney has signalled that the BoE is likely to begin normalizing rates later this year, and an early start to tightening can be seen as congruent with a lower stopping point. The housing market will feel the dual impact of tighter lending restrictions and rising mortgage rates, as these reset to reflect rising short rates. If there’s an accompanying rally in the value of the pound, this will dampen inflation pressures, and we can regard lower terminal rate guidance as more credible for the UK than the US, particularly with the BoE leaning towards “the front foot” to achieve gradual policy normalization.
In contrast, with the US, curve steepening risks are rising. Not only has inflation accelerated, but Mrs Yellen has been dismissive of the rise, signalling a willingness to fall behind the curve.
Last autumn, the market priced for an aggressive “hockey stick” of very low US 5y yields against relatively high US 5y5y yields, with the view that Mrs Yellen would stay ‘lower for longer’ but eventually need to catch up. But this year, the market has leaned in the opposite direction, pricing earlier short-rate normalization, reflected in higher 5-year yields, but with the expectation that the terminal rate will be lower as reflected in 2014’s decline in US 5y5y yields.
With inflation accelerating and labor market slack being absorbed rapidly, and Mrs Yellen apparently relaxed, it looks likely that the market needs to revisit its terminal rate expectations in the US, especially relative to the UK, and in this environment, US-GBP 5y5y spreads should rise – yet despite the spot US 5s10s curve steepening versus the UK, the 5y5y spread has failed to rise. We can expect that further US steepening should come from higher yields as the market questions the strength of US economic data, and more importantly, the inflation data. This suggests that there should be outperformance by GBP 1y1y vs USD and that the US 10y sector should lead the sell-off in both markets. But on a relative basis, the tightening of monetary conditions via the currency is likely to bear down on UK inflation in the near term, which also implies that the UK curve should have lower inflation premia relative to the US.
The risks to this scenario are inevitably geopolitical – and any rally in fixed income on the back of rising concerns on Iraq, Ukraine or similar, could be expected to push US yields lower relative to the UK.