Friday, 22 September, 2017
NWM Gilts: Trading the BoE- Could this time be different?
BoE rhetoric is not consistent with ‘one and done’ type policy adjustments. BoE Chief Economist Mr Haldane believes that the risk of tightening ‘too late’ is now greater than the risk of tightening ‘too early’. Raising rates once or twice is unlikely to offer much comfort. Mr Saunders aim is to ‘move from the current loose stance towards neutral’ and Governor Carney has suggested that the ‘case for a modest monetary tightening is reinforced by the possibility that global rates may be rising’.
NWM believe the MPC view the decision to raise +25bp as a decision on policy normalisation. If 50bp over three years was not enough (August Inflation Report signalling) the current 75bp priced by September 2020 is unlikely to be sufficient either.
How high could bank rate feasibly go? Inflation is 90bp above target. Estimates suggest that rate is rising and currently around 1.7%, according to the San Francisco Fed’s figures from Laubach, Williams et al. The global trend is evidently towards less accommodative policy and though Brexit risks are unique to the UK, BoE analysis suggests that around 75% of the movement in UK long-run equilibrium rates is driven by global factors. With the average mortgage rate for new house purchase and re-mortgage having fallen -165bp since the introduction of the FLS and cheaper unsecured credit (the average rate on a £10,000 personal loan having fallen nearly -400bp over the same period) a sizeable ‘buffer’ has evidently accumulated. NWM’s recent analysis suggests that Bank Rate would probably need to rise to at least 1.5%, possibly closer to 2.0%, to take debt-servicing costs to above their long-run average.
Their macro-model has 10y fair-value at 1.80%. NWM continue to believe that the fixed-income sell-off has further to run. This figure is a current fair-value estimate rather than a target and on a forward looking basis would be higher if, as we expect, the market prices in a faster pace of policy tightening. As BoE Governor Carney recently said ‘In coming years, it is reasonable to expect global term premia to rise as net asset purchases could shift significantly from the situation during the past four years when all net issuance within the G4 was effectively absorbed’.
Trades: With less clarity over the BoE’s reaction function and a greater focus on estimated rather than measured variables, such as slack and rates, NWM believe that the market still under-prices the risk of >100bp+ of policy tightening. Having closed their steepeners, NWM 10s30s Gilt flattener is working well (flattened 7bp so far, we think there is as much as another 15bp of flattening to go) and suggestion to pay 5F5Y GBP vs. EUR (regression weighted vs. a GBP 1F1Y/2F1Y flattener boxed vs. EUR) has made +17bp and still has a further 13bp before our profit target is reached.
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