Recent data from the UK have not supported the expectation for quicker easing by the Bank of England. Currently, two-year GBP swap rates are about 8 basis points higher than the lows seen last week.

Market Expectations for Rate Cuts

The market is looking for a rate cut in August and another in December. The stability of EUR/GBP indicates a perceived risk premium, with EUR/GBP estimated to be overvalued by 0.8%. The risk premium for the pound is partly due to the euro’s strength and concerns over the UK’s budget. The UK announced borrowing of £20.7 billion for June, which was higher than expected. While this increased borrowing hasn’t affected the pound much yet, it raises the chance of future tax increases, which could limit the pound’s appreciation. In light of this data, we suggest that derivative traders reduce their bets on quick rate cuts by the Bank of England. The rise in two-year swap rates shows that the market is adjusting to the idea of slower easing. Holding positions that benefit from higher short-term UK interest rates might be a smart choice.

Key Difference in Market Pricing

We notice a significant difference between market pricing and the likely actions of the central bank. Although headline inflation hit the 2% target in May, persistent services inflation, which was last reported by the ONS at 5.7%, remains concerning for policymakers. As a result, money markets have recently priced the chance of an August rate cut at less than 50%, making trades that go against this cut more appealing. The strength in the EUR/GBP exchange rate presents a specific opportunity. The estimated 0.8% overvaluation suggests strategies that favor the pound over the euro. This could involve selling EUR/GBP futures or options, expecting this risk premium to decrease as focus shifts toward the UK’s stubborn inflation. However, we also need to consider the UK’s rising budget concerns. The unexpected government borrowing of £20.7 billion in June, the third highest for that month ever, poses long-term risks for the currency. This fiscal pressure could lead to future tax hikes, likely limiting the pound’s potential for significant appreciation. Therefore, while we remain cautiously optimistic about the pound’s performance due to monetary policy, we recommend using options to manage downside risks from fiscal policy. Buying GBP call options could capture potential gains if the central bank remains hawkish while limiting losses if budget worries take precedence. Historically, currency markets struggle when a country’s fiscal health declines, which can cap currency strength even with favorable interest rates. Create your live VT Markets account and start trading now.

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