BOE-Fed Policy Divergence Drives Yield Gap to Widest Since 2000

  • Futures show 85% chance of BOE interest-rate cut in August
  • Survey predicts pound to drop to $1.27 by the end of the year

The extra yield that investors get for holding U.S. Treasuries instead of U.K. government bonds jumped to the most in 16 years as the divergence between the nations’ central banks’ monetary policy widens.

The yield spread between Treasury two-year notes and similar-maturity gilts suggests the Federal Reserve may tighten policy amid signs that the world’s largest economy is gaining momentum. Short-dated securities are the most sensitive to the outlook for central-bank policy.

Futures signal an 85 percent chance that the Bank of England will cut rates as soon as next month to shield the U.K. economy from any possible repercussions after Britain voted last month to leave the European Union. While Fed fund futures indicate only a 10 percent chance of a rate increase at this week’s meeting, there’s a 46 percent chance rates will rise by the December gathering, according to data compiled by Bloomberg. The U.S. central bank is due to announce its latest policy decision on Wednesday.

The yield spread “reflects rate expectations,” said Marc Ostwald, a strategist at ADM Investor Services International Ltd. in London. “There’s expectation the BOE will cut and increasingly now there is some concern that September is back on the table” for a Fed rate increase, he said.

The U.K. two-year gilt yield was little changed at 0.14 percent as of 4:21 p.m. London time. The price of the 1.25 percent bond due in July 2018 was 102.21 percent of face amount.

Spread Widens

Treasury two-year note yields rose two basis points to 0.72 percent, leaving the spread versus gilts at 58 basis points, the most since May 2000, based on closing-price data. U.K. gilts, have returned 5.6 percent in the past month, compared to 0.9 percent by Treasuries, according to Bloomberg World Bond Indexes.

Citigroup Inc.’s U.S. Economic Surprise Index, which measures whether data beat or miss analyst forecasts, rose to the highest level since December 2014.

Fed officials “have to acknowledge a better domestic environment,” Richard Cochinos, London-based head of Europe Group-of-10 currency strategy at Citigroup, said in an interview on Bloomberg Television. “The U.S. data, if you look at any surprise series, be it Citi’s or anywhere else, it has been running at the top end of the spectrum since 2015, so they have to say the domestic improvement remains very much on track.”

BOE Report

In its quarterly Asset Purchase Facility report, the BOE said the Monetary Policy Committee will continue to reinvest cash flows associated with maturing gilts held in its APF until the key interest rate “has reached a level from which it can be cut materially.” The central bank reiterated that the MPC “stands ready to undertake further asset purchases if it judges that additional monetary stimulus is warranted.”

BOE officials kept the main rate at a record-low 0.5 percent and maintained the asset-purchase target at 375 billion pounds ($492 billion) in their latest policy announcement on July 14. The next announcement is scheduled for Aug. 4.

The diverging policies of the Fed and BOE may push the pound lower. The median forecast in a Bloomberg survey of analysts sees sterling dropping to $1.27 by year-end, down more than 3 percent from the current level of $1.3131.

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