GBP Swaps: Tentative re-steepening; Corporate linkers

Tentative re-steepening, SONIAs narrowly mixed

A calmer session ahead of the long weekend after two days of post-inflation turmoil saw gilts end higher at the front end and steeper, after rising from the open. Amid reports of progress towards a debt deal in the US – and support for BOE rate hikes from UK Chancellor Hunt - 10y gilts only clawed back of few bp of their recent cross-market underperformance, leaving the spread versus Bunds still a touch above 180bps.

In the strip, SONIAs were anything from +3.5bps in Jun23 to -4.5bps in Mar24 today, in still elevated volumes of 55-65K for the back whites, albeit down from a record 136K-196K on Wednesday. The forwards now imply a peak for BOE Bank Rate of around 5.60% in Dec23, only about 5bps off the peak hit yesterday.

Gilts 2s/10s rose back to -14.4bps (+1.7) as the session wore on and 10s/30s steepened to 30.5bps (+2.9) as the long end underperformed. Asset swaps finished little-changed at 20.5bps (-0.3) in 5y and -58.4bps (-0.2) in 30y.     

Inflation fell at the front end today but both 1y RPI at 4.13% (-10bps today) and 5y RPI at 4.00% (-1bp) remain around  20bps higher than a week ago, following the 60bps overshoot in the data for core CPI. Linker real yields are also higher over the week, with 30y real yields at 1.21% up by about 20bps. Still, 30y real yields got close to 2.5% before the BOE stepped in last Autumn, so this week probably counts as relatively calm for linkers and the long end of the conventional curve.  Finally, a couple of 20y corporate linkers priced earlier this week  - for details, please see the section below.

Banks stay bearish 10y area of the curve

Although today’s tentative bounce had pulled yields down from this week’s highs, 10y gilt yields remain 15bps above where they closed before the CPI data, while 2s/10s is 18bps flatter. From here, while some banks reckon the front end has probably gone far enough, they remain bearish the 10y sector.

For example, NatWest has seen its 4.3% target for 10y yields taken out and now looks for gilts to hit 4.6%, with BOE Bank Rate rising to “at least” 5%.

With core inflation now expected to be still “well above 5%” at the end of the year, and not reach the BoE’s 2% target until mid-2025, NatWest reckons that inflation persistence is likely to trump policy patience. It continues:  

“Front-end gilts look close to fair value again….(However) at the longer-end of the curve…buyers are unlikely to have a meaningful bid for UK duration until there is confidence that inflation is on a clear downward trajectory and there is more certainty that Bank Rate is near a peak

Expect gilts to continue to underperform cross market and versus swaps, reckons the bank.

Indeed, near-term, NatWest doesn’t rule out an overshoot of its new 4.6% target for 10y yields.

“The lack of demand for UK duration from the natural buyers of gilts (overseas investors and LDI) has been notable this year”, it finds, and yields may still not be high enough to compensate for inflation or supply risks. While demand from some marginal buyers has picked up, the duration of this demand (from “corporate treasurers and retail,” according to NatWest) is likely to be “significantly shorter than the demand from the natural buyers that it is replacing”.

At the same time, the DMO is issuing a considerable proportion of the funding in the long end and linker buckets, and the BOE “continues to conduct quantitative tightening across the curve.”

4.6% would be higher than 10y gilt yields reached in the Autumn 2022 LDI crisis but NatWest expects the most recent selloff to be much less problematic. Rates are moving more slowly this year and LDI funds are better collateralised, it suggests.

Even so, higher rates could cause problems for a government keen to cut taxes before the next election, since the OBR assumes that “a 1ppt increase in gilt yields, all else equal, adds around £9bn to debt interest payments by 2027-2028.”

Higher rates also add to the cost to the Treasury of BOE QT. But NatWest doesn’t, as a base case, expect the BOE to pause QT barring “significant market dysfunction”.

Elsewhere, Bank of America now expects three more 25bps BOE rate hikes, in June, August and September, with the first 25bps cut only arriving in H2 2024. It also sees 10y Sonia at 4.5%, underperforming forwards and cross-markets. At the front end, 2y Sonia rates at around 5% “look fairer,” BofA reckons.

And, like NatWest, it is concerned about where demand for sterling duration will arrive from at current levels:

“It is hard to believe an effective net 2023 supply of gilts equivalent to 8%/GDP (DMO and BOE combined) can be met without heavy overseas involvement. Reversion to the norm of a larger current account deficit and reliance upon the kindness of strangers seems inevitable, informing our bearish stance on UK rates.”

A potential “negative feedback loop” between an “increasing shortfall” in the BOE gilt portfolio and the “deficit-increasing losses crystalized on sales”, together with “increasingly punitive carry” on the portfolio as rates rise are also seen by BofA as potential “fragilities” for the sterling market.

New issues: Brace of 20y corporate linkers 

• London Power Networks (A3) yesterday priced a £50m inflation-linked note 2.562% due 5 Jun 2043 with coupon and redemption linked to CPI. Lead is HSBC.

   

• South East Power Networks (A3) yesterday priced a £50m inflation-linked note 2.562% due 5 Jun 2043 with coupon and redemption linked to CPI. Lead is HSBC.

   

• Inchape PLC (Baa2) plans a GBP 5y bond through BNPP, MUFG, NatWest and Santander after meeting investors from May 30.