U.K. Bond Traders May Be Caught Napping With Fed Move This Week

Updated on
  • Futures signal no BOE rate increase until November 2016
  • U.S. boost could bring U.K. timing forward 3 months, UBS says

Traders of U.K. government bonds counting on Britain’s record-low interest rates continuing deep into 2016 risk missing the train, should the Federal Reserve raise its benchmark this week.

“There’s a popular belief that the sooner the Fed goes, the sooner the BOE will follow,” said Kit Juckes, a London-based global strategist at Societe Generale SA, referring to the Bank of England. “Given how far out the first BOE hike is priced by the market, you’d have thought that could come running back in towards Christmas were the Fed to go.”

Even with about one-half of economists predicting the Fed will move as soon as its Sept. 16-17 meeting, forward contracts reflecting investor perceptions signal the BOE Monetary Policy Committee won’t follow with a full 25 basis-point increase in its own key rate until late 2016. That means if Fed officials raise for the first time since 2006 this week, short-dated U.K. government-bond yields may jump as investors assess the pull on Britain.

Investors currently aren’t fully pricing in a BOE increase until November 2016, according to forward Sonia fixings data provided by ICAP Plc. That’s helped keep yields on two-year gilts subdued. They were at 0.64 percent as of the 5 p.m. London close Tuesday, down from 0.83 percent a year ago.

Yield Premium

During the month-long run-up to the Fed meeting, investors have gone from demanding a premium to hold two-year U.K. debt to now requiring extra yield-- 14 basis points, or 0.14 percentage point -- to hold the equivalent U.S. securities.

Any BOE officials who are looking to follow their Fed counterparts into tightening policy, and diverge further from the more accommodative stance of their euro-region neighbors, can count on help from Britain’s economy. The U.K. will grow 2.6 percent this year, outpacing even the 2.5 percent forecast for the U.S., according the median estimate of analysts surveyed by Bloomberg. That’s even as data Tuesday showed U.K. inflation returned to zero in August.

Governor Mark Carney said in July that the end of record-low U.K. rates is in sight and the time for such a move will become much clearer by the end of the year. All but four of 33 economists surveyed by Bloomberg say the market is overstating the length of time before an increase in BOE rates. That will happen in the first quarter, according to the median forecast in a separate survey.

McCafferty Alone

While Ian McCafferty’s call to raise rates was outvoted by his eight MPC colleagues last week, some officials seem increasingly keen to prepare the market for higher rates. Kristin Forbes said on Sept. 11 that rates may have to increase “sooner rather than later.” Martin Weale wrote in The Scotsman newspaper that they will need to rise “relatively soon.”

In the U.S., futures show a 28 percent chance the Federal Open Market Committee will raise rates this week. That’s down from a probability of 38 percent on Aug. 31, according to calculations based on the assumption that the effective fed funds rate will average 0.375 percent after the first increase.

That’s a more pessimistic view than that implied by a Bloomberg survey of 103 analysts. Forty-eight predict an increase in the Fed’s upper bound to 0.5 percent, four predict 0.375 percent and the rest called for no change.

Should Fed officials boost on Sept. 17, it would likely cause traders to move their predictions for BOE action forward by about three months, according to John Wraith, head of U.K. rates strategy at UBS Group AG in London.

A Fed increase “effectively brings the Bank of England into play,” especially if the pound weakens against the dollar as a result, Wraith said. “That would offset any worries they have got that sterling would appreciate against other currencies if they also start moving” rates up also.

“If the Fed don’t feel comfortable enough to hike with their much bigger, less currency-sensitive economy, it’s pretty questionable as to whether there would be a good case for the Bank of England to do so,” Wraith said.