FIXED INCOME ● RATES
3 August 2018UK gilt yields – low for longer 3
Our bullish duration stance is
reinforced 3
Cheap Italian insurance 5
Buy an umbrella while the sun is
still shining 5
Buy 26Y Austria 7
Backup in Eurozone yields offers
an opportunity 7
JGB 10-30yr flattener 9
A mere tweak 9
Buy-and-hold 1Y TIPS BEs 11
Buy the bond that falls out of the
index 11
US Treasury RV opportunity 13
Attractive front-end relative value
opportunities 13
Supply outlook 15
Volatility corner 19
Credit ratings 22
Trade tracker 23
Disclosure appendix 27
Disclaimer 31
ContentsFIXED INCOME ● RATES
3 August 2018
Table 2. Stay received in 4y1y Sonia
Trade Time horizon Entry (date) Target Stop Current Rationale Risk
Rec 4y1y
Sonia
3mths 1.32%
(14 Jun 18)
1.10% 1.50% 1.36% Front-end
mispricing
growth risks
Wage growth
rises further
Source: HSBC, Bloomberg
Our bullish duration stance is reinforced
For the gilt market, the most important part of the Inflation Report was the analysis of the neutral
rate. We use this to model where front-end yields should trade and conclude they should be
lower. We remain received in 4y1y Sonia, and are watching August 2019 MPC which is almost
fully priced for another hike. Aside from this, although the decision to raise rates was more
decisive than the market had expected (9-0 vs 7-2), the rest of the message from the BoE was
almost unchanged.
UK gilt yields – low for longer
The BoE’s guidance to a low neutral rate of interest is the most
important takeaway from the Inflation Report
Our expected policy rate is lower than the market is pricing,
supporting a bullish duration stance
We stay received in 4y1y Sonia, and we are currently watching
August 2019 MPC
Daniela Russell
Head of UK Rates Strategy
HSBC Bank plc
daniela.russell@hsbcib
+44 20 7991 1352
We are already long, but are
looking to add further
Figure 1. Front-end market pricing versus paths in recent Inflation Reports
Source:HSBC, Bloomberg, Bank of England
0.6%
0.7%
0.8%
0.9%
1.0%
1.1%
1.2%
1.3%
Q3 18Q4 18Q1 19Q2 19Q3 19Q4 19Q1 20Q2 20Q3 20Q4 20Q1 21Q2 21Q3 21Q4 21
1m
so
nia
fw
d r
ate
(%
)
May QIR
Current path
Aug QIR
FIXED INCOME ● RATES
3 August 2018Expected policy rate is lower than the market is pricing
The Bank estimated the trend nominal policy rate to be in the 2-3% range, but added that the near-
term equilibrium is lower than this. Front-end market forward rates reflect expected levels of Bank
Rate, and also incorporate a measure of uncertainty around the path of the economy. The market
estimate of UK policy rate five years from now (5y1m Sonia) is currently around 1.37%. This
expected equilibrium rate should reflect all possible scenarios. In a simple three-scenario model let
us assign (1) a 45% probability that the BoE tightens policy gradually towards a near-term neutral
rate of 2%, (2) a 45% probability that Bank Rate now remains on hold at 0.75%, (3) and a 10%
probability that rates fall back to the previous low of 0.25%.
Based on these weights, this gives a number of around 1.25%. This is already below where the
market is pricing, and we do not think these probabilities are unreasonable especially as the near-
term r* may be even lower than 2%. In fact, we would more realistically put less weight on scenario
1, and place greater emphasis on scenario 2, while we also think rates may be cut even lower than
25bp in the next easing cycle. If we instead use a 30:60:10 split, we get to 1.08%.
It is worth remembering that we are well into the business cycle so just how feasible is it for the BoE
to tighten policy towards the terminal rate before the next downturn emerges Furthermore, the
probability of a return to the zero lower bound is often underestimated. The neutral rate has fallen
since the crisis of ten years ago, and while it could rise slowly if some of the short-term factors
weighing on it ease (e.g. Brexit uncertainty, fiscal consolidation), it is unlikely to rise anywhere close
to pre-crisis levels. The long-term structural forces of poor productivity, high debt, demographics etc
will continue to supress rates. Moreover, as MPC member Vlieghe noted in his September 2017
speech on neutral rates, the volatility of growth has also increased and risks to growth have
become asymmetric (i.e. downturns more extreme than upturns). Therefore rates may stay closer
to zero for longer periods than would previously have been seemed possible.
Staying long duration, and watching August 2019 MPC
We were already long duration heading into the Inflation Report, and retain this stance. We are
received in 4y1y Sonia and are now watching August 2019 MPC which is almost fully priced for
another hike.
We think it is noteworthy that there was no explicit pushback on the market profile in the August 2018
Inflation Report, despite the fact it was 10-15bp lower than in May (Figure 1). The BoE effectively
endorsed the notion that Bank Rate should rise by 25bp per year over the next three years. Given
that questions about the underlying strength of the economy are still not resolved, Eurozone growth
has slowed further, there are rising trade risks, wage growth has been soft (and has continued to
disappoint the Bank’s forecasts, as in Figure 2) and Brexit uncertainty remains high, it seems
optimistic for the market to be so certain that another rate rise will follow in August 2019.
Plenty of upside potential from
long front-end positions
Market underprices the risk of
a return to the zero lower
bound
BoE is walking…but could
soon be stumbling
Figure 2. BoE has been consistently disappointed on its wage forecasts
Source:HSBC, Bloomberg, Bank of England * Lower bound of MPC member Vlieghe’s guidance of “one to two” rate rises per year
024201220132014201520162017201820192020
%
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ar
Actual wage growth
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