The gilt and sterling sell-off has steadied after Prime Minister Andy Burnham appointed John Healey as Chancellor and said he would adhere to fiscal rules while using any flexibility within them. Markets are now focused on how that flexibility might be deployed to fund spending, but fiscal plans may not be clarified until the October budget. Until then, uncertainty around fiscal policy is likely to cap relief rallies across gilts and GBP.
UK May labour market indicators pointed to slack. The unemployment rate held at 4.9% for a second consecutive month, while the vacancies-to-unemployment ratio stayed at 0.4, which is below an estimated equilibrium of 0.50. In rates, the swaps curve implies a full 25bps Bank of England hike to 4.00% in November and 60bps of tightening over the next 12 months, leaving policy above the BoE’s estimated neutral range of 2.00% to 4.00%. With the economy operating below potential, that configuration raises the scope for a downward adjustment in BoE rate expectations versus GBP.
Trader Guidance During Fiscal Uncertainty
We advise derivative traders to remain cautious and avoid buying into temporary relief rallies for the British Pound (GBP) and UK gilts. Although the market stabilized after John Healey was appointed Chancellor, the lack of clear fiscal policy details until the October budget will keep investors on edge. Historically, similar periods of political and fiscal transition have capped sterling’s upside, much like the volatility seen during previous UK leadership changes.
Labor Market Data and Policy Implications
Our bearish view on GBP is reinforced by the latest labor market data, which shows the UK unemployment rate flat at 4.9%. Furthermore, the vacancies-to-unemployment ratio remains stagnant at 0.4, well below the 0.5 equilibrium level. This persistent labor market slack indicates that wage pressures are cooling, which will likely drag on economic growth.
Currently, the swap markets are pricing in a 25-basis-point Bank of England rate hike to 4.00% by November, which sits at the very top of the estimated neutral range. Because the UK economy is operating below its potential, we recommend traders short GBP against major currencies and go long on short-term interest rate futures. We anticipate a downward adjustment in BoE rate expectations over the coming weeks, which should put downward pressure on both gilt yields and the pound.
