GBP Swaps: Gilts whacked as Coronation exacerbates traits

UK Five pound note with King  Charles 17 Jan 2023
Lacklustre trading in a holiday-fixated start to May has let gilts drift in an underperforming manner. Traders and NatWest examine the problem.

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  • Gilts whacked as Coronation exacerbates traits

  • NatWest on gilt underperformance

  • DMO announces 2063 syndication team


    Gilts whacked as Coronation exacerbates traits

    One of the themes emphasized by gilt traders at UK GEMMs in recent weeks is the invisible weight of supply and its particularly gritty inflation that the market is carrying around with it. As this new financial year moves well into its second month, the weight is being felt more and more, and is particularly expressed via underperformance in cross-market sell-offs.   


    Those underperformances have also led to outperformances in rallying markets at times for RV reasons, but increasingly gilts are underperforming there in those circumstances too. This was visible for all to see today when strong NFP data sparked a spike in yields that sent 10y up to 3.80%, 15bps higher on the day.


    Looking at the state of play in this slightly untypical week, both in terms of central banks and the number of holidays bobbing around, one senior gilt trader at a leading GEMM said that “really the market is very listless and underperforming all the time.”


    “The Coronation isn’t helping, there are more people out trying to maximize their time off and that leaves GBP fixed income swaying with the wind a bit and underperforming whether gilts are going up, down or sideways… it’s not the usual gilt beta.”


    This market mode has been particularly bad for long linkers where the wound-licking by LDI continues to sap demand resulting in a week of underperformance in the long end of the linker curve versus peers. In nominal gilts, the trader added, “things have turned around a bit after yesterday’s APF (where the BOE sold £770m of 2044-2072 gilts), it’s been more stable since, unlike long linkers.” Real yields rose 9-10bps at the long end today although at least that was accompanied by 2-3bps of breakeven widening.


    With traders in the GBP fixed income market more interested in the upcoming break, it was to events elsewhere that direction was sought, so after tracking/underperforming soggy Bunds ahead of the NFP data, the 10y spread spread threatened to test 150bps before retreating to 148.8bps, another 2.7bps wider on the day (and 4.8bps wider versus 10y USTs). The question of when to buy gilts versus rival EGBs/USTs is likely to become more of an issue once the  cakes and booze have been processed, and royal-themed bunting decanted to the recycling bin.


    At the 4:15pm close, 2s/10s was a bps steeper and 10s/30s was 1.5bps flatter. In ASWs, 2y was +1.5bps at 15bps, 10y was -1.2bps at -9.8bps and 30y was +0.1bps at -55bps. 


    NatWest on gilt underperformance

    Cross-market underperformance, across the curve, has been the theme in the UK over the past few weeks. Today the Financial Times published an article about this phenomenon, largely blaming soaring borrowing costs in 2022-23, and also Liz Truss's attack on the UK's reputation for fiscal rectitude. Across the curve, this has been most pronounced vs the US, but the underperformance has been broad based vs Europe too. How can we explain this, NatWest asks today? The bank says:


    • Fundamentals – sticky inflation and better growth? Unlikely. “The past two months has seen two consecutive higher-than-expected inflation prints in the UK, and some better-than-expected macro data. These improvements should not be overstated (but) help explain relative underperformance in UK rates but not the high absolute level. A recession is still widely expected this year and headline inflation is still expected to fall rapidly as the year progresses, in line with other regions.”


    • Bank sector concerns? Perhaps versus USD but less so versus EUR. “Underperformance at the front-end coincided with banking sector stability concerns. The UK has so far been well insulated, which certainly goes some way in explaining the underperformance vs US rates. But concerns in Europe have been considerably less marked than in the US as well, and the UK vs Europe spread has also widened considerably, especially at the front-end.”


    • Mortgage paying? Maybe in the front end. “BoE data… show a small shift in new advances to individuals being taken at a shorter term than before. This goes some way to explaining a higher term structure in front-end UK rates because it may have driven an increase in mortgage-related paying of front-end swaps. But the shift is small and… unlikely to justify persistent underperformance in UK rates on today’s scale.”


    • Supply in the long end? Maybe, according to NatWest. “The UK supply schedule has been heavy so far this fiscal year. In order for the market to digest all this supply, the clearing price will gradually have to shift lower and lower. Although there has been evidence of demand at auctions (large order books, small tails etc) this hasn’t come without a cheapening of gilts both outright and cross-market.”


    In conclusion, NatWest argues that the UK economic fundamentals fail to justify the underperformance of the front end in particular. It recommends “being long 1y1y GBP vs 1y1y USD where the dislocation is the largest, especially as we head into next week’s BoE meeting where we see the risks skewed towards a dovish market reaction rather than hawkish.”


    And in the long end it says that high levels of supply will continue to drive underperformance. It says investors should switch 10y gilts vs 3y USTs into 2s10s GBP steepeners. “Demand will return, but not at these yield levels. We continue to target 4.3% in 10y gilts. We’ve been in cross-market steepeners (short 10y gilts vs 3y treasuries) since February, but now prefer to hold these steepeners on the gilt curve given our front-end UK views.”


    DMO announces 2063 syndication team

    The DMO said today that it has appointed Goldman, HSBC, MS, Nomura and RBC as leads on the upcoming syndicated launch of a new Oct 2063 conventional gilt, scheduled for sale during the week of May 15.