Goldman: Risk Reward Improving For Front-End/Belly Gilt Swap Spread Tighteners

Late on Friday Goldman Sachs noted that “the recent rise in UK rates is likely to prove stickier than the LDI-related sell-off in September 2022, as it seems to be inflation-driven and a period of higher and more restrictive policy rates will likely be necessary to control inflation.”

• “This suggests the increased fiscal costs for the UK government will also prove more long-lasting.”
• “Alongside ongoing BoE QT, this is likely to continue to pressure Gilt swap spreads tighter, with the long-end of the Gilt curve currently exhibiting the most weakness. But there are reasons to think front-end or belly spreads have additional room to tighten.”
• “First, front-end swap spreads have been dragged notably wider by the directional relationship with the level of rates, for example due to paying flows on the swap leg.”
• “Second, we expect the DMO issuance strategy to continue to skew towards shorter-dated securities.”
• “Third, last year’s experience has shown that the BoE is willing to be flexible around QT in the event of supply indigestion, possibly offering eventual protection against sharp weakness in long-end Gilts.”
• “Although our economists have recently revised their terminal rate forecast to 6%, we think that after the recent repricing, the hurdle is somewhat lower for CPI or labor market data to provide relief.”
• “For that reason, we have left our 10y Gilt forecast unchanged at 4.50% in Q323. We see this tentative case for receding uncertainty as also supportive of 2-5y Gilt spread shorts in upcoming weeks.”