Pound Sterling Bond Yield Differentials Offer Clues About Short-term Outlook

• GBP showing reverence for yield differentials
• Hints of pressure on GBP & support for USD
• Could be a limitation for some commodity FX

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Pound Sterling has recently shown greater reverence for bond yield differentials with some other currencies and in the context of the cautious inflection now creeping into the Bank of England (BoE) policy stance, this potentially says something about the outlook for other currencies including the U.S. Dollar.

Sterling rose against many major counterparts during the opening session of the new week but by Tuesday was still carrying losses against all but the Japanese Yen and Swiss Franc for the recent month and the change in BoE policy stance has been an instrumental factor behind those declines.

The BoE warned in March and Governor Andrew Bailey left little doubt in a speech last week that market expectations for Bank Rate have likely reached levels that would be unsustainable for the UK economy.

Above: Pound to Dollar rate shown at daily intervals with spread, gap or differential between 02-year UK and U.S. government bond yields as well as selected moving-averages. Click image for closer inspection.

Deputy Governor Sir Jon Cunliffe also spoke in depth on Monday about why the BoE’s next economic forecasts in May are likely to have inflation sitting even further below target at the other end of the horizon than in February.

“Much will depend on the course of the conflict and the evolution of sanctions. But in all probability, it will intensify and prolong the surge in inflation and tighten the squeeze on household incomes. The consequent drop in demand through household consumption and business investment will, to an extent not yet clear, be greater than we thought in February,” Deputy Governor Cunliffe said.

“There is little monetary policy can do to offset the externally-generated pressures on prices and hence the very high inflation numbers we are certain to see over the coming quarters. Nor can monetary policy do much to offset the squeeze on household incomes that will result. What we can do is to ensure that when the current, extreme pressures pass, inflation returns to its 2% target. In my view, that will require balancing two very different risks,” he also later said.

All of this matters for certain important UK government bond yields and in part because the Pound has been rising and falling alongside differentials between bond yields of the UK government and countries of some other counterpart currencies in recent weeks.

Above: GBP/JPY shown at daily intervals with spread, gap or differential between 02-year UK and German government bond yields as well as selected moving-averages. Click image for closer inspection.

The relationship may be suggestive of yields - and factors that drive them such as monetary policy - being a dominant influence in those exchange rates and to the extent that this remains the case they may also be implying something about the outlook for Sterling and a bunch of other currencies.

A rate differential rises when the bond market of that currency underperforms the bond market of the other currency, leading yields to rise relative to the other, which is significant in the context of the BoE's evolving policy stance.

Above: Pound to Canadian Dollar rate shown at daily intervals with spread, gap or differential between 02-year UK and Canada government bond yields as well as selected moving-averages. Click image for closer inspection.

The March policy decision cast doubt over whether the BoE will meet market expectations for Bank Rate to top 2% by year-end, which imposes at least a temporary limitation on the upside for UK government yields in most circumstances and may even eventually exert a downward pressure.

This implies that if UK rate differentials are to rise at all in a Sterling supportive manner during the weeks and months ahead, it probably wouldn’t be without downward pressure emerging on other countries’ bond yields.

Above: Pound to Australian Dollar rate shown at daily intervals with spread, gap or differential between 02-year UK and Australian bond yields as well as selected moving-averages. Click image for closer inspection.

In the absence of this and in any event of further increases in other countries’ bond yields, UK rate differentials themselves could be likely to remain under pressure, if not fall further, and could in that case weigh heavier on Sterling during the weeks and months ahead.

The big and overarching thing implied in all this is that either the outlook for Sterling is still very broadly bearish, or the outlook for the Dollar is still generally bullish because in the short-term at least any yield-induced recovery in Sterling could possibly only result from a reversal lower in other countries’ yields, which would likely also weigh on their currencies.

Above: Pound to New Zealand Dollar rate shown at daily intervals with spread, gap or differential between 02-year UK and New Zealand bond yields as well as selected moving-averages. Click image for closer inspection.