Decoding Curve Flattening: Exploring the UK's Inverted Yield Curve and Rate Cut Expectations

Unlike previous instances of hawkish re-pricing, the rise in front-end rates has struggled to propagate to longer maturities. The resulting curve flattening means the UK curve is fast catching up to the inverted levels of its US equivalent. The limited level of inversion has long been a puzzle to us, given UK policy rates are already significantly in restrictive territory, and as the UK is facing similar growth headwinds to its developed market peers, thus justifying commensurate rate cut expectations.

 

One possible reason for the lack of flattening was fears that active quantitative tightening – outright gilt sales – were putting comparative steepening pressure on the curve. Another potential explanation could also have been expectations that, once at their peak, policy rates would need to be held there for longer. We have more sympathy for the former explanation, especially now that more inflationary data is finally resulting in curve flattening.

 

The upshot is a more inverted curve in the UK for longer than in the US in particular, where we can point to (a) more progress against the Fed’s inflation target and (b) a clearer list of catalysts for inflation to revert to target.

 

Sterling rates now price higher rates for longer at the Bank of England than at the Fed

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Today's events and market view

The European releases calendar is thin with only eurozone industrial production expected to rebound in April from a dismal print in March.

Bond supply mostly consists in Germany adding a 10Y auction to an already busy week on the supply front (it launched a new 30Y green bond as well as auctioned 5Y debt yesterday).

 

The June FOMC meeting looms large on today’s markets. Consensus (6 out of 108 respondents favour no change in Bloomberg’s survey) and market expectations (a 25bp hike is priced with a less than 10% probability) are for no change in rate at this meeting after the May CPI report came in roughly in line with estimates yesterday. The lack of rate action will likely be offset by a more hawkish tone, including confirmation that a July hike is possible.

 

Ahead of the Fed, the US release calendar features PPI, which is expected to continue showing deflationary forces at play.