iFlow > FX: G10 & EM
Published every Thursday, provides a detailed analysis of global foreign exchange movements in major and emerging economies around the world together with macro insights.
Geoff Yu
Time to Read: 5 minutes
EXHIBIT #1: EURUSD AND GBPUSD IMPLIED VOLATILITY
Source: BNY, Bloomberg
Our take
The pound has been the big mover in G10 FX markets this week but we would not exaggerate the level of stress associated with the situation in the gilt market. On the one hand, we should acknowledge that the return of the positive sterling-gilt correlation requires close monitoring as there are echoes of the “mini-budget” of 2022. However, starting points matter: current Bank of England rates are lower; inflation is sticky but not rising sharply; there are no forced sellers in the market and the Bank of England is not introducing marginal quantitative tightening, all of which are factors that would have exacerbated gilt market stress. For much of the summer, we have held the view that GBP valuations were also starting to look toppish, and iFlow showed that cross-border hedges were around 20% below the rolling 12-month average, as opposed to 20% above the same benchmark for the EUR. Implied volatility across European government curves have ticked up, but remain well below “Liberation Day” levels, let alone the highs in 2022.
Forward look
The rise in U.K. yields this week was also accompanied by record demand for a 10-year gilt auction. Similarly, after the initial move in yields in the U.S., we saw heavy demand for long-dated Treasurys in Q2 this year. If the EUR and GBP continue to weaken, then OAT and gilt yields may even become attractive. The U.K. debt management office (DMO) announced that this week’s 10-year gilt auction, which attracted a record £140bn in bids, ultimately had a 40% allocation for foreign investors. This is materially above the 31% share of total holdings published by the DMO as of the end of 2024. The “non-resident” share of OAT holdings is 53%, though there is probably less of an FX impact as many such investors are likely Eurozone-based with firm OAT mandates. The headlines are difficult for 10 Downing Street and the Hôtel de Matignon, but letting currency weakness absorb fiscal discounts is the most painless way of sustaining external financing.
EXHIBIT #2: : QUARTERLY SMOOTHED VOLUMES OF U.K. AND FRENCH CASH AND SHORT-TERM INSTRUMENTS
Source: BNY
Our take
Currency and funding markets are the first ports of call to detect market stress. For long-only investors, whether as a result of sudden or anticipated risk aversion, iFlow will tend to identify a surge in flows into cash markets (defined as cash and short-term instruments not issued by governments), while transaction volumes rise. Since 2022, we can see that there have been some periods of sharp gains in cash transactions in France and the U.K., but it is only this year where the surge has been simultaneous (Exhibit #2). This was during the post-“Liberation Day” correction in markets, where the heavily liquidation of equity risk likely resulted in a significant inflow into cash. At that time, we did identify strong interest in European short-term debt as this was the only region which offered sufficient liquidity for rotational purposes.
Forward look
On an idiosyncratic basis, we find that periods of governmental stress – even when directly linked to fiscal risk – do not tend to generate spikes in cash transactions. For example, while turnover in U.K. debt was very high in September 2022 during the “mini-budget” episode, cash flows were even higher during the period of risk aversion associated with the banking sector in the U.S., the peak of U.K. cash transactions (relative to its long-term average) remains from summer last year as the Labour government identified fiscal gaps and the U.K.’s borrowing and spending outlook faced material revision. As upcoming adjustments are similar in nature, the marginal impact appears to have worn off. It is only broader exogenous factors, such as U.S. tariffs, which introduce new forms of risk into markets which can generate a cash surge. For the U.K. and France, without “unknown unknowns,” cash preference looks set to remain manageable.
EXHIBIT #3: BANK OF ENGLAND BALANCE SHEET REDUCTION VS. SHORT-TERM REPO PROVISION
Source: BNY, Bloomberg
Our take
Recently we wrote about the prospect of the “final days of QT” for the Federal Reserve to ensure that funding markets in the U.S. continue to function well. The dynamics of bank reserves in the United Kingdom is very different but the potential for stress arising from central bank quantitative tightening is similar. As the QT process involves the active selling of bond holdings, doing so in a steepening environment does have the potential to increase stress. In 2022, such linkages were apparent as the mini-Budget was announced not only in a steepening environment, but also as the BoE announced plans to begin the QT process through gilt sales. The execution of the plan was suspended until gilt markets calmed, and to allay fears of sudden reserve scarcity, the Bank of England established a short-term repo facility to lend bank reserves at the base rate. We can see that usage of the facility has continued to grow, but at levels far below the level of QT itself (Exhibit #3).
Forward look
As of the end of August, the Bank of England’s total reserve balances amount to £667bn. This is still well above the “Preferred Minimum Range of Reserves” (PMRR) of £345bn–£490bn, which BoE Governor Bailey highlighted in 2024, and the number itself, in his words, “is likely to change over time. Everything here is endogenous.” Throughout the steepening episodes this year, the BoE has been faced with questions surrounding selling gilts “into a falling market” but there is still very little indication of funding stress. After all, the BoE calls QT a process through which interest rate risk held by the central bank is “unwound” and reintroduced to the financial system. Despite the shocks seen in recent years, the financial system remains readily available to absorb higher interest rate risk. If it transpires that the PMRR is at a much higher level – which may only be clear after the threshold is crossed – immediate adjustments are possible in response to stress: In 2022, the BoE was back in the market buying gilts just six days after announcing the sales plan. The next gilt sales annual review is expected to be released alongside the monetary policy decision in September, and assumptions may change.
We acknowledge that the market is concerned about fiscal sustainability in Europe and the current budgetary impasse in the U.K. and France may require higher term premia – which is already materializing through weaker currencies and steeper curves. However, in terms of market structure and functioning, we don’t see much sign of stress for now. There have been several “dress rehearsals” in liquidity and funding over the last few years and with each test, central banks have established facilities to strengthen resilience. Nonetheless, vigilance is undoubtedly high at present. Currency weakness is a form of loosening; if further support is needed, we expect central banks in the region to start matching the Fed in beginning discussions surrounding adjusting balance sheet run-offs while sovereign debt markets remain nervous.
