Watch the 2-year yield spreads!

Yesterday evening, while most of the people were watching the World Cup first game’s kick-off, BoE Governor Carney and UK’s Chancellor of the Exchequer George Osborne both gave a speech at the Mansion House. The topic on the table was their concerns about the UK housing market as a rate hike would stress mortgage debt and therefore threaten the recovery. Until now, investors and traders were pricing in a rate increase somewhere in Q2 next year; however, Carney surprised the market by stating the Official Bank rate hike ‘could happen sooner than markets currently expect’. It immediately shifted the UK rate curve higher, with the 2-year now trading at a 3-year high of 0.852%. If we have a look at the chart below, we can see that the UK-US 2-year spread (in red) rose 10bps sending Cable (in yellow) to the roof. After it nearly reached its strong psychological resistance at 1.7000 on May 6, the British pound had entered into a bearish momentum against the greenback until it test its support at 1.6680 (mid-April lows) a few times. Despite strong UK fundamentals, the market is more concerned about the rate ‘neutrality’ debate and which central bank will consider starting raising its benchmark rate early next year.

Cable-2Y

(Source: Reuters)

However, this week’s strong employment data in addition to Carney’s hawkish speech played in favour of the pound which hit its psychological 1.7000 resistance against the US Dollar yesterday. We reached our target on EURGBP at 0.8000 based on our previous article (Some overnight developments), which has also been driven by the 2-year UK-EU yield spread (in orange, reversed scale RHS) as you can see it below.

EG-2Y

(Source: Reuters)

With the FOMC meeting next week, we assume that the volatility will remain low and especially in the FX market. Carry trade currencies (especially the Kiwi) should continue to outperform in this market. We saw yesterday that a currency that will remain under pressure will be the Swedish Krona (SEK) after the CPI came in at -0.20% YoY in May. If deflation continues to stagnate at around 0%, the Riksbank will have to intervene later this year but cutting its benchmark by another 25bps (it currently stands at 25bps), therefore impacting the currency.

FOMC meeting: the impacts

As expected, the Fed reduced the asset purchase programme by another $10bn in April to $55bn, adding $25bn of agency MBS and $30bn of LT Treasuries to its holdings every month. The surprise though came from the upward revision to the Fed funds rate, which is expected to increase to 1% or more by the end of 2015 (up from 0.75%) and to 2.25% by the end of 2016 (up from 1.75%). US interest rates increased sharply after the statement, pushing the value of the US Dollar higher (US Dollar index was up 60 pts to 80.10).

In addition, US policymakers lowered the 2014 GDP growth range to 2.8% – 3.0% (from 2.8% – 3.2% in December) and are targeting a 6.1% – 6.3% jobless rate by the end of this year (see the details below). With the unemployment rate standing close to the 6.5-pecent threshold (6.7% in February), Janet Yellen announced during her first conference as a Fed chair that the central bank would shift to a more qualitative approach and will consider a ‘wide range’ of variables instead of relying mainly on the unemployment rate.

(Source: Federal Reserve website)

Now let’s review the impacts of the Fed funds rate forecast change. Firstly, as you can see it on the chart below, the 10-year US yield increase by 10 bps to 2.77%, sending Gold to end-of-February lows (trading at 1,328 after the statement).

(Source: Reuters)

The FOMC meeting also put the Euro under pressure, a currency that has remained resilient in the middle of this Risk-ON / Risk-OFF market driven by Russian-Ukrainian tensions and the weakening Chinese Yuan episode. EURUSD, which had been traded around the 1.3900 level (1.3850 – 1.3960 range) for the past couple of weeks, was pushed back towards 1.3800 (1.3810 after the statement), frustrating the bulls (who were expecting 1.4000) and easing ECB concerns about a ‘strong exchange rate’.

EURUSD-FOMC

(Source: Reuters)

Eventually, Cable broke its 1.6545 support and found support slightly above the 1.6500 level. As you can see it on the chart below, the plunge in the 2-year UK-US spread (purple line) from 31.5 bps to 22.5 bps pushed the pair (orange) to mid-Feb levels. The 2-year spread has been one of the major drivers of Cable since Carney adopted the forward guidance in August last year. As unemployment rate has decreased faster than expected and is now standing close to the 7-percent threshold (7.2% in the three months to January), traders have been speculating on a rate hike in the first quarter of 2015. However, some MPC members put the British pound under pressure stating that a ‘strong exchange rate’ could weigh on the BoE’s decision to start tightening. With policymakers’ recent comments and an annual inflation at its lowest level since 2009 (1.9% YoY in January), the market is now pricing in a BoE action in the second quarter of 2015.

GBPUSD - Sp

(Source: Reuters) 

UK Budget: In the early afternoon, the Chancellor of the Exchequer Osborne presented the new budget and as expected, it contained a few surprises in the aggregate numbers of the deficit path (real news was the incentives for savers, which we are not going to cover in this article). As the UK economy is expected to accelerate this year (2.7% according to the Office for Budget Responsibility – OBR), the deficit is expected to decrease gradually in the following years and switch to a small surplus of 0.2% in 2018/19 according to the OBR.