Sunday, 10 August 2014

week of the 11th August - BoE/UK economy and the GBP.

A year ago, at the August inflation report, the BoE effectively enacted forward guidance, the GBP had an incredibly choppy session trading from 1.52 to 1.55 in the space of a few hours. I recall it well, as I'd just got back from holiday and was playing Dead Island 2 on one screen, while having twitter and my terminal open on the others. I was glad to stay out of the markets that day as I was getting myself re-acquainted with the markets. This week, we have the BoE once again, and it provides Carney with a perfect opportunity to provide a little more certainty with regard to the 1st rate hike... which is now seen by many in 2014. Renewed CPI projections could be a big mover for the market - a shift higher in the baseline estimate would most certainly bring forward expectations to November time.

UK CPI -Next release for CPI is Aug 19th, however the projections are likely going to be more important.

However, I sit on the camp that sees a 2015 rate hike, one of the key indicators which the BoE have been telling us to watch is Average earnings growth, which they expected to rise to 2.5% by year end (GLWT). Given its persistent weakness, I think the BoE are going to be extremely cautious during the hiking cycle, and will try and put it off as long as possible.

The UK labour market has been incredibly strong, with consistent -30k prints on the claimant count, and the headline rate of unemployment dropping far faster than anyone expected... So we /should/ see a pick-up in wage inflation as we get closer and closer to the NAIRU.

Looking to the markets now, it's clear that the GBP is trading rather weak going into the BoE, presumably with the growing fear that they may confirm (by means of forecasts and language use) a spring 2015 rate hike... With the recent GBP drop, we've also seen STIRs (specifically Short sterling Z4s) rise back into their 2014 range.

Dec '14 Short sterling
For the meantime, the GBP is trading incredibly closely to relative interest rates, most notably the implied yield spread from M5 STIR contracts (Short sterling - Eurodollar)

GBP vs M5 spread

This does make a lot sense too, both central banks are not too far away from hiking cycles, and both economies look to be performing well in my opinion, as such the smallest changes in rate path expectations affect the GBP. Essentially, the US hiking cycle is supposedly to start later but is going to be a tad more aggressive (using 5y5y rates as a rough proxy for terminal rates, we can see US rates are 50+bps higher than UK ones)

UK 5y5y (white) US 5y5y (red)

However, it seems that the GBP is far more sensitive to what is happening on the (very) short end, so essentially for the time being, the GBPUSD is a rather simple bet on the distance between 1st hikes. Which puts the current cable rate equivalent to a 6 month gap... it was closer to 9 months when we traded at 1.72, but we've seen short sterlings weaken, and US rates move higher so we've dropped back to 6 months.


GBPUSD rolling quarterly change vs CESI spread
Also, data has turned against the cable in the past few months, and this will be a defining factor in determining that time gap between hikes, and thus the Cable itself

Morgan Stanley's M1KE (month to the 1st hike) recently went under 12 months for the US... reinforcing the Summer '15 view that many have (tho this will be very data dependent, especially if wage inflation ticks up in the US). However, this all seems pretty fair to me, so right now the GBP is in a wait and see mode regarding the BoE, until then cable will mostly be a USD story.

A trade idea from a few weeks ago was selling GBP vs EUR (about 1/2 way down here)

However, given that I'm winding up my positions for my summer holiday, I've decided to very closely watch the EURGBP next week and look to cover around where we are (preferably 0.8020) 

EURGBP model
Still trading a little cheap to my model, but its close enough now to not mean much, hence my willingness to take profits here.

The EUR should be interesting next week too, in my opinion. We saw a hint of what maybe to come on Friday, with a sizeable short covering rally taking us back above 1.34. However I still think there is scope for a move back closer to 1.35 (which would be ideal to load up with Long term shorts)

Model (white) vs EURUSD (red) and the spread
So we could see a bit of short covering, which would also serve to help the EURGBP pre-BoE, which is what I'm looking for so that I can exit that trade.

For the EUR, we also have German GDP... but something is telling me that I won't give a toss about it (as its Thursday) - however a negative print, which is slowly starting to be expected really does throw a spanner in the works of this eurozone recovery...

We have seen the DAX trim a good thousand points or so since they won the World cup, but finally looks "cheapish" relative to basic valuation methods, but also against US equity. Even though we have seen a pick up in risk (as per my controversial posting of RU CDS' vs. DAX) European assets are looking like good value, especially on the periphery. If the markets really are in some short term risk on/risk off mode, then ceterus paribus, we should see some demand for EUR equity into the beginning of next week especially after the rebound in US equity on Friday, Also given that (on technical metrics) we are oversold and trade at better values this could also serve well to boost the EUR.

relative EU/US equity vs EURUSD

Also, on this "risk off" move in the markets last week... the EURCHF traded down to 1.2130, while 1M vols spiked higher (ok, ok, they are still crazy low, but its quite a move)

EURCHF 1 month ATM vol
Using this spike in vol and lower spot price, I sold 1.2125 puts for expiration at year end... merely 45 points tho.

EMFX was well supported on Friday, and likely to be supported even more if we see the DXY topple over and head to 81. We saw relative implieds volatility spike higher in EM land, but hardly anywhere to be concerned, trading at an average 3.3 vol points higher than a G10 composite on 1month tenors (however mean is 2.5, so only really 0.8vols) I opted on Friday morning to sell some topside USDRUB and USDTRY 25D calls (2.25 on $TRY) 1 month expiration, as we saw quite the spike higher in risk reversals (from 0.5 to almost 2.5 on 1m 25D for USDTRY)

USDTRY 25 delta 1 month risk reversal
However, given the attractiveness to fund EM carry (and DM to some extent) with EURs recently, an EM rally could serve to weigh on the EURUSD, however I don't expect it to be a hugely significant factor.

In other news -- *BREAKING: JEREMYWS' Aaa RATING PLACED ON REVIEW FOR DOWNGRADE AT EDEXCEL

Rumours are strong that we'll see a downgrade to Baa1 on Thursday... but We'll see. 

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