Over the past few weeks, we have noticed an interesting development in the US interest rate market. Since the beginning of the year, the 2-year interest rate has constantly been increasing on the back of a tightening monetary cycle ran by US policymakers; it is now trading at 2.65%, up from 2% in early January. However, the CFTC Commitment of Traders report shows that speculators have not followed the trend and have been reverting their positioning since January (as opposed to the 10Y positioning). As we can see it on the chart, total net specs positions increased from -329K contracts on January 30th to -19K last week (July 17th) on the back of a sharp reduction in shorts from -735K to -492K and some increase in longs (+67K), hence completely diverging from the 2Y yield. What generated this sudden reversal? We think that the rise in the 2Y may be done and that the short end of the curve could settle around the current levels for a while.
After two hikes this year, the Fed Funds rate currently stands at 2%, and another two moves are expected according to market participants for the rest of 2018 (at the September and December meetings). With the US economy expected to grow at 4.5% in real terms in the second quarter according to GDPnow forecasts, US policymakers have benefited from strong momentum in US fundamentals and a dull summer market with the 10Y yield trading quietly below 3% and equities steadily recovering from their February lows. The SP500 index is up 300pts from its low reached on Feb 9th, and currently trades 50pts away from its all-time high reached in January prior the equity rout. Even though financial markets have still got to ‘face’ the August low-liquidity period, which is the most volatile month if we look at the past twenty years, US policymakers have got all the conditions not to disappoint market participants in the following FOMC meetings.
However, we think that much of the action concerning US monetary policy has been priced in by investors, and we can’t see any more hawkish surprises coming in the following months. Therefore, the 2Y may stabilize around its current level at 2.7%, which could explain the reversal in the specs positions. It will be interesting to see how the short-end and the long-end of the curve react to a sudden rise in uncertainty by the end of the summer, pushing down drastically the probability of a hike at the September meeting.
Chart. 2Y US yield vs. CFTC Specs Positioning (Source: Reuters Eikon, CFTC)
When we look at the balance of payment of a specific country, we usually look at the current account and financial and capital accounts separately. The current account is the sum of the country’s net trade and its primary and secondary incomes. In this article, we look at the development of UK’s primary income since 2000, overlaid with EURGBP exchange rate. The primary income is the sum of all earnings arising from the provision of a factor of production, such as labour (compensation of employees), financial assets (equity, debt, reserves assets), FDIs…. As you can see, earnings on FDIs and debt securities have been the main components of the primary income over the past two decades, with earnings on equity securities starting to become significant since 2011.
The UK has been persistently running a current account deficit since the mid-1980s on the back of a net trade and primary income deficits. The fall in direct investment income since 2011 due to decline in world commodity prices in addition to a strengthening pound (against the Euro), combined with persistent negative earnings on equity and debt securities have weighed on UK primary income over the past 5 years. The UK recorded a record primary income deficit of 18.2bn GBP in December 2015, a few months after EURGBP fell below 0.70. UK investments of foreign companies have persistently generated healthy dividends and interests for their overseas owners, hence income flows (equity and debt securities) have been flowing out of the country.
More importantly, we can notice a strong co-movement between UK FDIs earnings and EURGBP exchange rate over the past decade. The pound experienced a significant depreciation due to Brexit and fell from 0.7 to almost 0.90 against the single currency in roughly two years, from Q2 2015 to Q2 2017 (i.e. EURGBP went up by 25%). As a consequence, earnings from FDIs switched back to the positive territory in the end of 2016, and have stabilized around GBP 5bn over the past year. This clearly shows the investment relationship the UK has with Europe, hence we think it is interesting to look at the exchange rate (EURGBP) as one of the leading indicators of FDIs earnings (lag 2 to 3 quarters) in periods of sharp FX moves.
At this stage, we don’t see higher volatility on the exchange rate in the medium term and we think that EURGBP may stay within its 0.87 – 0.90 range for a while. However, Cable is currently 5 to 10 percent undervalued according to some FX valuation metrics, therefore FDIs earnings could increase a little bit more on the back of a weak US Dollar with GBPUSD converging back towards its equilibrium value (1.37 – 1.40).
Chart: UK Primary Income vs. EURGBP (Source: Reuters Eikon, DataStream)