GBP Swaps: Waiting for front end ASWs to land; Buy the dips

Everest peak
Traders look at the malaise in shorter gilts, despite a slight bear-steepening move today. HSBC ponders the peak.

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Waiting for front end ASWs to land 

HSBC: Beware steepeners, buy 5y5y duration on the dips



Waiting for front end ASWs to land

A relatively quiet Friday, devoid of significant US data ahead of a three-day weekend stateside, saw traders happy to take stock of where the market finds itself as the promise of Spring edges tantalisingly closer.  


One trader at a leading GEMM this lunchtime in London spoke with relief how much better in many ways 2023 has so far been, compared to the second half of 2022.


“In the grand scheme of things gilts have normalised a huge amount. They now trade in line with USTs and Bunds, using the same rough combination of guidance from both that was the case up until Autumn,” said the swapper.


If the long end is perhaps a little quieter than before, and pension flows a bit more of a staccato contribution rather than the smooth melodic buying of yore, the trader said the part of the market that is still struggling to trade in a definitively normal way is the front end.


He said that “liquidity in the front end is definitely not great, although it is not as disassociated (from other markets and from historical trading patterns) as it was. The problem is that the way the DMO has structured repo means that you can only borrow gilts at 75bps over the repo rate, which makes front end gilts very expensive.”


Referencing last week’s tricky, uncovered QT sale (see GBP Swaps: Day of two halves ends on worrying note) he added that “it’s therefore not surprising to see front end gilts underperform swaps by 50 or 60bps in the last few months (since Nov the 5y ASW has tightened 44bps to 43bps), and until we get a strong idea where terminal rates are (this hiking cycle), and as long as QT continues, it will be hard to get excited about the front-end.”


Which sort of explains why 2y gilt yields, for example, are at their highest since mid-October and peak Truss, despite comments from BOE Chief Economist Huw Pill this week that were among the most dovish remarks from an MOC centrist this hiking cycle. SONIA futures are 1.5-4.5bps lower in the whites and reds today, outperforming SOFRs but lagging EURIBORs. 


When that peak in BOE rates comes though (and HSBC is cautiously optimistic that it will come quite soon, see below) the front-end should become lively again, and even now the curve flickers between flattening and steepening moves, although steepening moves are more frequent as one would expect with an end to hikes coming closer.


Today gilts opened as much as 11bps higher in yield in the 10y after hawkish Fed comments hit USTs, since when the curve has broadly rallied part of the way back, before starting to flatline since lunch. Currently 2y yields are +2bps, the 10y is +5bps at 3.54% and the 30y is +6bps. The 10y ASW is -0.9bps at -14.2bps and 30y is -1.6bps at -55.8bps.


In linkerland, real yields are 3-10bps higher as the curve bear flattens. 1y RPI is -10bps at 3.91% and 2y is down about as much as gas futures slide, while 30y RPI is unchanged at 3.38% ahead of a week where holiday trading conditions will fade and the pre-Easter sprint will begin in earnest. In itota, the 10y was lifted this morning at 27.25bps after trading at 27.5bps earlier this week. 


HSBC: Beware steepeners, buy 5y5y duration on the dips

As markets continue to debate when and where the BOE's Bank Rate may peak, strategists at HSBC today had their say about how to negotiate what it sees as a relatively short period of data-driven volatility ahead.


It notes that earlier this month the “BoE dropped its previous language that ‘further increases in rates are likely’. Instead, there is now full conditionality over future rate hikes and the MPC will decide based on incoming data – particularly developments in core services inflation and private sector wage growth.”


“Renewed data dependency is injecting considerable volatility. A bear-flattening trend has dominated for much of the last two years due to the expectation – and subsequent delivery – of tighter monetary policy. The 2-10-year segments of various global yield curves are now inverted, including in the UK, with many investors beginning to wonder whether now is the time to position for renewed steepening as central bank policy rates near their peaks.”


HSBC says that while it sees scope for bull-steepening, the fact that the front-end “is looking cheap after its recent underperformance” and the fact also that the market is pricing a very slow easing path by historical standards, means that it might be argued that “there is considerable scope for a significant bull-steepening of the yield curve.”


“Although we agree that risk-reward increasingly favours steepening, we see several reasons why investors should be wary before rushing in. We prefer a strategy of adding duration on dips.”


HSBC reckons that the market is over-estimating the peak of the cycle and is underestimating the speed at which the hikes may be unwound. It concludes that “Sequentially lower hiking cycle peaks underpin our view that while curves can steepen in anticipation of renewed easing, long-term steepening potential is perhaps more limited than is widely recognised. Our analysis suggests that investors need not rush into 2-10-year steepeners. Instead, our preference remains to add duration where it is cheapest. In our view, buying gilts 5Y5Y forward remains attractive. While a choppy range is likely in the near-term, we expect yields to fall over the course of the year as rate cut pricing intensifies. Even if we are wrong, longer-dated forwards should be less exposed if monetary policy becomes more restrictive in the near-term.”