Philip Wee, FX Strategist
Eugene Leow, Rates Strategist
DBS Group Research
FX: GBP is still at risk to a disorderly Brexit
The British pound mounted rallied to above 1.26 from below 1.25 yesterday. By agreeing not to run for the next general election in 2022, Prime Minister Theresa May survived a no confidence vote in her Conservative Party, and shedoes not have to endure another leadership challenge for a year and be pressured to resign.
Yesterday’s vote was considered a Pyrrhic victory. The 200-117 margin revealed the arithmetic shortfall in the 320 votes needed for the Brexit withdrawal agreement (WA) with the European Union to pass the House of Commons. It would also steel the resolve of the Democratic Unionist Party, the Northern Irish party that the Conservative Party depends on for its majority in parliament, to remove the Irish backstop from the WA. In addition, there is a need to pay attention to Scotland, where the opposition Labour party could run a no-confidence motion against the government. We believe that the pound is still at risk to a disorderly Brexit and another fall towards its post-Brexit referendum low of 1.20 is on the cards.
Rates: German yields are too low
10Y German yields are set to end 2018 lower than they were in end-2017. They pushed as high as 0.77 in early February but with French politics taking centre stage recently, yields have pushed below 0.3%. Note that German Bunds continued to rally despite the European Central Bank (ECB) paring purchases over the past few quarters. However, with asset purchases set to cease by the end of the year and the market pricing in considerable risk premium across other European assets, we reckon that German yields are too low.
As the ECB steps back as a ready buyer, there are two key reasons why investors would want to add to German debt at these levels – pre-empting another round of quantitative easing or believing that risks in the other core Eurozone economies are still going to be elevated. There is a low probability of the former taking place, though we acknowledge that any further normalisation (rate hikes) are now likely to pushed into 2020.
Tweaks to the reinvestment policy (likely to be announced later today) should not have a significant downside impact on yields. European Parliamentary elections in May 2019 suggests that political risks will likely stay elevated in in the coming quarters.
That said, at these low absolute yields, we think German yields would head meaningfully higher once negative narrative eases somewhat. Moreover, the EUR/USD basis swaps curve has tightened across all tenors, rendering, the pickup for USD-based investors negligible. We see 10Y German yields touching 0.8% by end-2019.