- Bond markets have front run the Fed's rate hikes. The US 2-year treasury yield has risen from 0.73% to 2.6% in 2022.
- This rise in US yields has made the US dollar more attractive vs. lower yielding currencies including the GBP.
- Yield and interest rate divergence favors the USD in the near to midterm as US rates can still move relatively higher.
- GBP could rally in the near term if the Bank of England surprised the markets with a more hawkish stance.
The GBP/USD is trading around 1.31, near its November 2020 lows. Where may it go from here?
Wrangling Inflation is key focus of Central Bank Policy
On March 16 the Federal Open Market Committee (FOMC) raised the Fed Funds target rate from 0-25bps to 25-50bps.1 This was after inflation had reached 40-year highs and the unemployment level was comfortably below its natural rate. Bond markets were aware of the need for tighter financial conditions vis a vis higher interest rates and front ran the Fed with aggressively moving 2-year yields up from 0.73% to a high of 2.62% to date in 2022. After the March 16 meeting, Fed officials indicated they would be much more aggressive in combating inflation that greatly exceeds their target rate.2 Money markets are now expecting 100bps of additional Fed hikes over the next two FOMC meetings3.
Chart 1: UK vs. US Core CPI YoY (%)
Sources: SVB FX & Bloomberg, 3/30/22
US 2-year yield front running the Fed
As the “Bond King”, Jeffrey Gundlach of DoubleLine Capital has noted, the US 2-year yield has historically been a pretty good leading barometer as to how high the Fed will raise interest rates.4 This week the 2-year reached 3-year highs at 2.6%, whereas the Fed Funds rate target range is 0.25% - 0.50%. From the most recent Fed policy rate projections, or "Dot Plots", 2.75% is the median guidance for the "terminal rate" where the Fed will stop hiking interest rates.5 Given the relationship of the 2-year and Fed Funds rate, it wouldn’t be surprising to see US 2-year yields rise about 25bps higher in the midterm.
Chart 2: US 2-year yield vs. Fed Funds Rate
Source: SVB FX & Bloomberg Financial L.P. April 5th, 2022
Pound pushes lower as US yields diverge from UK
As illustrated in chart 3, one of the main drivers of FX markets are short term interest rates, with 2-year yields a good reflection of divergence across currencies. Until June of last year, the spread between the UK and US 2-year yield was relatively flat. Then US yields began rising at a fast pace. While the US 2-year treasury has risen from 0.73% to 2.6% in 2022, the 2-year UK gilt has only risen from 0.68% to 1.47%. Higher US yields have continued to accelerate in 2022 and the USD has strengthened on this rise in yields. If the increase in short term US yields continues, outpacing the UK over the next few months, the USD could see a tailwind from this yield divergence.
Chart 3: UK and US 2-year yield divergence vs. GBP/USD
Source: SVB FX & Bloomberg, April 5th 2022
The Bank of England could be full of surprises in May
The Fed was late to the party compared to the Bank of England (BOE) in raising interest rates and ending expansionary monetary policy. Now the Fed will have to be more aggressive in the months ahead. Over the next three policy meetings, the market has priced-in two 50bps hikes from the Fed and only 25bps hikes from the BOE6. Assuming these rate hikes are priced into the GBP/USD, there’s a risk that BOE surprises markets and hikes by 50bps at their next meeting on May 5, which may cause the GBP to rally.
Table 1: Central Bank Pricing Activity priced into the Market
Source: Bloomberg Finance L.P. April 5th 2022
Of course, this massive rise in yields could slow down if bond markets believe they will reach the Fed's terminal rate before Fed hikes actually reach that level. Or the BOE could become more hawkish against inflation in its May 5 meeting, setting expectations for higher rates and narrowing the yield differentials. BOE members have shown a hawkish side as recently as February when 4 of 9 members voted for a 50bps hike. Should this hawkish side reappear, the GBP should see a lift.
The rise in US yields has made the US dollar more attractive vs. lower yielding currencies including the GBP. Yield and interest rate divergence favors the USD in the near to midterm as rates can still move higher. However, the GBP could rally in the near term if the Bank of England surprised the market with a more hawkish stance.
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