Calls on GBP - because Brits will fight inflation with stiff higher rates. Maybe

[The_Ni]

tl;dr - U.K. inflation jumped to 9%. Bank of England might have to reluctantly crank up rates bigly. GBP will reverse against USD if that happens, and we can capture that through the ETF, FXB.

U.K. inflation hit 9%; Brits in a bit of a bother

The U.K.’s annual rate of inflation jumped to a forty-year-high in April, the highest level recorded by an industrialized nation since the start of the global price surge last year.

Consumer prices in April were 9% higher than a year earlier, a jump from 7% in March and the highest inflation rate since March 1982, the Office for National Statistics said. The pace is now the highest recorded by one of the Group of Seven rich economies in about a year. (Source)

The rate is expected to pass 10% later this year.

Bank of England sounds gobsmacked …

The Bank of England Governor doesn’t seem too keen to raise rates much partly because much of the drivers are supply side, and partly because the economy is already slowing down. He recently said:

https://twitter.com/Steven_Swinford/status/1526217461040926722

(^^ Good summary of what the Governor said; checked deets.)

Additional context:

The BoE kept its forecast for economic growth this year at 3.75%, but slashed its forecast for 2023 to show a contraction of 0.25% from a previous estimate of 1.25% growth. It cut its growth projection for 2024 to 0.25% from a previous 1.0%.

Those forecasts were based on bets in financial markets that the BoE would increase interest rates to about 2.5% by the middle of next year and the central bank signalled that was probably too much.

It said it expected inflation would fall to 1.3% in three years’ time, the biggest undershoot relative to its 2% target since the 2008-09 global financial crisis, after unemployment rises and the cost-of-living squeeze hits the economy.

Rates of 2.5% by the middle of next year… when inflation will be 10% by the end of this. Bit of a gulf there. Wider than the English Channel.

… But what if the Gov’ner goes “bollocks…!”, and pulls a Volcker?

Rapidly rising inflation opens up the possibility that the BoE actually increase rates much more, and more quickly, especially if it keeps rising faster. Bit like Volcker did all those decades ago.

It will have many effects, and one of them will likely be the rapid appreciation of the GBP as markets adjust not for the spot rate, but the estimated terminal rate. Precisely as the USD became even more #1 when Feds raised rates by a paltry amount of 0.75%, but markets projected a terminal rate around 3%. Which ended up causing this over the last year (USD-major currency pairs, along with Dollar Index DXY):

Wouldn’t it be nice to catch that movement in the other direction, if the GBP starts appreciating relative to the USD, thereby mean reverting? In other words, go long GBP?

There’s a cheeky ETF for that - FXB

One way to play this possible appreciation of the GBP is the ETF FXB. It basically gives spot exposure to the GBP vs the USD. FXB superimposed with GBP below as confirmation.

Depending on how quickly things move, the 10% reversion could happen in months. 10% doesn’t sound like much, but considering the less-than-a-year-timeframe and the fact that currencies have major momentum and so we don’t have to tend to this daily, it could be a decent place to get some slow-and-steady return.

Also, the USD has been on a bit of a tear lately, and unless JPow indicates a more accelerated rate hike schedule, the GBP could adjust a bit anyway. We might be seeing some of this, in addition to the rate hike expectation, in that little curl at the end of the graph there.

Unfortunately there isn’t much by way of option liquidity, so would not be advisable to play there. But IV is ludicrously low though - 14% in May and sub 10% in Sep, so if you can get an MM to be your counterparty, more power to you!

The move: Wait and see.

For now, I’ll sit and wait. Need just a little bit more confirmation. The Governor sounded like he was capitulating, not gearing up for a fight by channeling his inner Volcker. Part of it could be because supply shortages and energy input prices account for more than half of the current inflation, and demand destruction is such a sad way to have to address this.

Nevertheless, neither of these things will ease, given China is being China and sanctions on Russia will only get stronger. At some point, he may be to pull the bandaid and crank up rates.

Wanted to put this on our radars now so we are ready and keep monitoring for that reversal.

And also to ask if anyone has any other plays we can consider around miffed Brits taking it to inflation.

Thanks to @macromicrodick for preliminary discussions on this on Discord that helped me think through some of these things!

gbp fxb usd

[macromicrodick]

Toppa the mornin to ya, Guvnah! This is a real sound thesis and in true Valhalla fashion, hopefully early! I’m just trying to follow along here but there’s multiple places saying how the USD has peaked.

Here’s Goldman saying that the USD is probably 18% overvalued and would start depreciating in a recession:

U.S. dollar could lose value during a recession, Goldman Sachs says

[The_Ni]

@macromicrodick

Toppa the mornin to ya, Guvnah!

Putting some USD on where the Pound should be - got a bunch of FXB commons @ 120/ea.

[The_Ni]

What with the additional rate hikes becoming part of the narrative in the US and the Brits not really making much noise, have sold the FXB position at a 2% loss. Will keep an eye on this and perhaps get back in later.

[Castle]

I was to the understanding that FED raising interest rate is generally making the Dollar more stronger as US Bonds are higher yielding and safer bet. Wouldn’t that make the Dollar value appreciate rather depreciate?

[TheHouse]

Morning @The_Ni,
What are your thoughts on playing puts on the ETF #fez (Spdr Euro Stoxx 50) to gain some exposure to Europe’s economic challenges? Ray Dalio’s recent 10 Billion $ short positions on Euro companies (Many in the Euro Stoxx 50) may be a signal for an entry. Lots of data coming out of Europe still pointing in the same direction, while energy and other commodities as you have mentioned doesnt look to be easing anytime soon, so long as the tensions with Russia remain. Looks like there is some decend OI on the chain aswell.
Thanks for your input as always !

[The_Ni]

Very interesting - would certainly be worth diving into. Will check it out more over the weekend.

At first blush, looks like $FEZ has been hurt quite a bit already - is lower than pre-COVID levels. Wonder how much of the bad news market is internalized already.

[The_Ni]

@castle apologies, totally missed your question earlier.

Agree with you, all else being equal - Fed raising rates will make the GBP weaker, and not stronger. However, in this post, was banking on the fact that the BoE would actually now start raising too. And not just raising, but maybe even raise at a faster clip than the Fed.

That has not come to pass - they raised by 0.25% only, bringing rates to 1.25% two weeks ago. (Some more details here.) Even though inflation is 11% in England.

FXB has continued to fall as a result:

This thesis has, therefore, not come to pass. And so have made no moves on this yet.

[The_Ni]

Politicians will not miss an opportunity to f*ck up. Britain’s seem to be intent on f*cking up more than others.

In a highly inflationary environment which the BoE is trying to combat inflation by raising lending rates, the govt has decided to cut taxes and give subsidies to both people and industry, undertaking accommodative policy that hopes to avert a bad recession but complicates stamping out inflation.

As a result, we are seeing what we normally only see in emerging markets - rates are up, but currency is plummeting.

One can play this using FXB, the topic of this thread. I won’t be, for now anyway, as there are just too many ways to get hurt playing forex even when politicians are not doing weird stuff.

Here are some more details; excerpts pulled from the WSJ:

The British government Friday unveiled the country’s biggest tax cuts since the early 1970s, a bold move aimed at kick-starting growth at a time of global economic turmoil but one which spooked investors and sparked the biggest one-day selloff of the pound since the pandemic roiled markets in March 2020.

The package of tax cuts, paired with subsidies for households and businesses to cope with a surge in energy prices, was aimed at boosting the flagging U.K. economy amid stubbornly high global inflation and growing economic gloom in Europe. Instead, it may have only added to global worries by causing a market backlash.

The pound, which had fallen by nearly a fifth this year against the dollar, slid another 3% Friday to $1.092, hitting a fresh 37-year low and easily outpacing a 1% decline in the euro against the greenback. U.K. borrowing costs also rose quickly, with yields on both short-term and longer-term government bonds shooting up by more than a third of a percentage point, a massive jump in bond-market terms. The 10-year U.K. government bond yielded 3.76%, higher than the U.S. equivalent for the first time in several years.

The fiscal package pits the government’s pro-growth policy against a Bank of England that has tightened lending rates along with much of the industrialized world. The central bank raised its key lending rate by a half-percentage point on Thursday to 2.25%, its highest in 14 years and might now consider an emergency rate increase, some analysts said.

Further complicating matters for debt markets, the central bank has pushed ahead with plans to sell off bondholdings it acquired as part of its attempts to ease the money supply in previous years. That means both the government and central bank will be adding to the supply of bonds for investors to absorb.

The package of subsidies and tax cuts—which will be largely funded by borrowing—will cost more than 150 billion pounds, equivalent to $169 billion, over the next couple of years, analysts say. The government said it would borrow an additional £72.4 billion to fund the package in the short term. However, the overall borrowing in the coming five years could be closer to £300 billion.

Before the government’s package was announced, many economists were bracing for a long but shallow recession in the U.K. as price increases cut into consumers’ incomes. However, the scale of the government intervention could stave off recession next year, with the U.K. economy instead bumping along at just above 0% growth, according to analysis by JPMorgan.

The central bank said Thursday that the government’s energy subsidy would likely reduce peak annual inflation to 11% from 13% later this year, but could add to inflationary pressure in the medium term. Analysts expect the Bank of England to continue to raise rates in part because the new stimulus package will add to price pressures in the longer run. That could dent longer-term economic growth.

[macromicrodick]

With additional comment from the Finance Minister that further tax cuts are on the way, the pound sterling is continuing to show weakness. Now there’s an expected 150bps rate increase by the BoE by the end of November but it won’t matter unless this new government starts to show some more austerity. Basically the disconnect between government policies and central banks, as is the case in Japan right now, is not going to lead to more currency weakness.

UK bond yields have surpassed US yields for the first in 8 years.

Pound hits record low after tax cut plans

[macromicrodick]

I sincerely believe with all of my heart that The_Ni should be the next governor for the Bank of England as his original thesis would have offset much of the pain the UK is experiencing now.

Not to do a victory lap (+$23.59!) but I was just testing how the liquidity on FXB and wanted to share my experience:

1. I had to wait for over 30 minutes to get filled at the mid point for my single ATM call.
2. Seeing the pound down this morning (would’ve been more, thanks BoE!) I just put in a quick limit sell order before open. I probably left about $10-$15 on the table but it really was a test run.
3. The next test will be to see after the IV rush at open if I can get still sell easily.

Thanks again, The_Ni for bringing this to our attention.

[macromicrodick]

Why Bond Yields Dropped In The US Yesterday

Don’t want to clog up The_House Stagflation thread with UK news but here was a succinct summary of why bond rates dropped yesterday to match the BoE’s intervention:

*“The news sent shockwaves across risk assets as investors attempted to front-run the BoE and potentially other central banks by buying downbeat bonds. As a result, bond yields sunk, and this triggered a short-covering rally in gold and stock markets,” Fawad Razaqzada, market analyst at City Index, said in a note. **"*The intervention by the BoE has given rise to speculation that other central banks might follow suit in a similar way. It remains to be seen whether this will be the case. But traders are buying bonds today and will be asking questions later."

Yields on both UK and US debt sharply dropped, with the 10-year UK yield sinking 50 basis points to 4%.

Dow jumps 548 points as the Bank of England's intervention calms market panic...

As of this morning in PM, the 10-Yr is already up 10bps and now above 3.8%.

GBP Currency Impact - Further Room To Drop

[macromicrodick]

When Truss announced that they weren’t going to go through with tax cuts for the wealthy, many thought this was a softening of the hardline Growth Policy the current UK government is touting in order to mitigate the hurt caused by inflation. The GBP responded accordingly and stabilized it’s drop.

But it appears they have only carved out that part of their policy and still insist on policies to stimulate growth without providing where this funding is coming from. This is inflationary any way you look at it. All this means is that attacks on the Pound are back on and the BoE will again find itself defending gilt yields or the GBP.

Politics is now driving monetary policy and currency markets. Somethings to keep in mind:

https://twitter.com/FinancialTimes/status/1577931700532912129?s=20&t=tgL9sifXfb2KZXnGii2qSA

The pound slips again versus the dollar after brief rally as markets weigh UK...