Steep and Steepening - the Sterling yield curve
13 November 2009
The Technical Trader's view:
WEEKLY CHART DEC10 SHORT STERLING
Few could deny the exuberance of the Short Sterling market - now well above the long- run all-time-highs from February and May this year - they will surely be good support and help ratchet the market better again.
Now contrast that with the DEC11 chart...
WEEKLY CHART DEC11 SHORT STERLING
See how further down the futures curve the current price is far below the highs of Feb this Year.
The market is languishing bearishly rather than making new highs.
Now look still further along the yield curve - at the Gilt chart.
WEEKY CHART UK GILT
In February this year the market re-tested the High established in 2003 around 124.
Thereafter it fell.
So far it has found support at the 116.08 level.
But notice that there has been no bounce from there.
The market is yet more bearish than the DEC11 Short Sterling.
The yield curve is steep and looks set to steepen. Bears should look along the futures strip (and beyond) to establish positions while bulls should buy as close to the Spot Month as possible.
The Macro Trader's view:
The Short Sterling and Gilt contracts represent two markets reacting to similar concerns, but sometimes moving in opposite directions.
The Short Sterling market has remained largely bullish throughout this year, apart from the occasional correction that occurs in any bull or bear market.
Over recent months we have watched as data has turned increasingly bullish of the economy:
1. the PMI Services report began a sustained recovery that now reports sold growth,
2. The housing market defied all predictions of collapse and not only began to stabilize, but is now reporting regular month on month price increases, and
3. Retail sales, while depressed, held up well given the recession.
And so developed a view of the economy which expected recovery to emerge sooner rather than later.
So Q3 GDP was a complete surprise to us (and others) when it came in as -0.4%. At first we thought the ONS has made one of its classic mistakes. But the Bank of England's Quarterly inflation report, released yesterday, made no mention of this. Indeed, despite £200.B of QE and interest rates at almost zero, the BoE still forecast CPI below target in two years time.
There is a short term spike to above 2.0%, but policy makers expect that to quickly correct. All of this is based on the current market yield curve, which has priced in a gentle tightening. Moreover it also incorporated the current Government's fiscal tightening plans.
If the opposition Conservative party fulfills opinion poll predictions and wins next year's General election due in May/June, the fiscal tightening on their current plans will be even greater. Clearly on that basis, the outcome for CPI inflation should be even lower, meaning the Bank can leave policy on hold for virtually all of next year.
This offers Short Sterling traders a convergence trade.
The Gilt has all of this to consider, plus the unprecedented debt build up. But the market has traded within a wide range since June. On more than one occasion it has tried to break both the upside, on weak growth, and the downside on debt and future inflation concerns, but has failed to find the impetus to follow through, leaving gilt traders searching for direction
In short, the Short Sterling market is concerned with inflation and how policy is likely to react to it. Since there currently is no inflation there has been no policy response. This allows the bullish convergence trade to cash to take place.
But the Gilt is faced with all that, plus a massive debt build up and periodic threats from credit rating agencies to the Sovereign debt rating. The Gilt looks confused short-term, with nothing like the capacity of Short Sterling to rally, yet unable to sell-off.
Mark Sturdy
John Lewis
Seven Days Ahead
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