GBP/USD analysis: Sterling is no longer supported by gilt yieldsFor most of 2022, currencies were helped by rising yields on short-term government bonds.
When looking at the UK bond market, rising gilt yields have reflected expectations of future interest rate hikes by the Bank of England, but ultimately they begin to incorporate more political and fiscal risks into their rate premium.
Given the turbulent political climate in the UK over the last two months, the volatility of UK gilts has been exceptionally high. Liz Truss announced her resignation as British Prime Minister on Thursday, following a hectic 45 days in office that included a gilt market crash and a U-turn on her budget proposals.
The most recent economic data, meanwhile, continue to paint a gloomy picture. September UK retail sales fell 6.9% year-on-year, a sixth consecutive monthly decline and worse than market expectations of a 5.0% drop. The GfK Consumer Confidence indicator went up a little bit to -47 in October, but it was still close to a record low of -49 in September.
The pound is now behaving differently than the yield on 2-year gilts. Rising gilt yields now reflect not only the inflation/interest rate environment, but also the higher investors' uncertainty about the stability of the UK bond market. Episodes of rising gilt yields over the past few weeks have been correlated with a weaker pound.
This playbook can be expected to continue in the coming months. If 2-year gilt yields were to surpass the 4% threshold once more, this would likely put downward pressure on the pound, which could eventually test and break below 1.10.
