Friday, July 18, 2014

Trade Ideas: USD vs GBP Short End/ Belly Convergence

Following up on my last post where I promised a closer look at the convergence trade of USD and GBP short term rates

Based on the latest data on both (We have the latest June prints for UK consumer prices, US prints are till May, the next US prints are due this Tuesday). The US CPI has recovered from last year's lows firing on all major component - food, housing and transportation (partly driven by energy prices). For UK, CPI prints have softened. The energy component seem yet to pass through and food has been weak as well. The stronger components have been housing, education and restaurant + hotel expenses. On pure price terms, if the trends remain, US will soon catch up a lot with the UK inflation, and inflation expectations should be priced upward accordingly as well.

Crucially, the one of the core drivers of forward looking inflation, the wage growth and personal income growth, have been much robust in the US (part of the productivity puzzle in UK employment, where presumably a large part of the employment gain has been at the expense of productivity and wage growth). Neither of them particularly impressive, nonetheless the US is doing better in forward looking terms. The counterpart of the productivity puzzle of the UK employment has been the dropping participation rate for the US. However, a large part of that has been attributed to changing demographics (retiring baby boomers) and the latest such study (opens PDF) is from the President's Council of Economic Advisers. If that is the cause, the overhang on the inflation should be less.

Also, the credit side of the story is much better for the US as well. The household credit growth and credit demand picture also support a stronger come back of inflation in the US compared to the UK.

Ignoring jitters about the compression of the term premiums and the asset price bubbles, or the recent round of Risk Offs, US inflation is poised for an outperforming compared to UK. And this means trades for short end convergence in USD and GBP. The price momentum was against this trade even a few weeks ago, and now the weekly moving average of the spread (on 5y swap rate) has cross the 50 day MA. 

Time is ripe for this trade!

UPDATE: Another study on the participation rate concludes similar

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