ITC – GBP swaps – Connecting Short-Sterling to the 10y
There is a relationship that exists across GBP, EUR, USD markets, which is that the 10y swap rate is a linear function of the 5th forward LIBOR and the 5th-9th spread.
With Short-Stg jumping around at present because of change BoE opinions, we thought it worthwhile to restate this. We wanted to see if this statistical relationship can explain the near 5bp decline in GBP 10y swap rate today.
The formula is (0.82% + 0.81*5th SStg implied rate + 1.18* 5th-9th spread). The plot of the actual and estimated 10y rate is below. We would not get too hung up on whether there is a gap between the lines; clearly Central Bank’s are using monetary policy in innovative ways these days and this has caused subtle differences between the lines to develop over time. Yet daily changes in 10y GBP swap rates are still closely following the relationship highlighted above.
As an example, if you believe that the Bank of England might put the bank rate 20bp lower than the market is pricing in a year’s time, then the 10y swap rate might be expected to decline by 16bp (80% of 20bp), assuming that you believe that the pace of changes between one and two years will remain the same as the market prices in.
Today, the 5th forward Short Sterling implied rate is 5.5bp lower and 5th-9th shows 1bp fewer implied rate hikes. These movements combine in the same direction so the estimate suggests a 5.6bp decline in the 10y GBP swap rate. This compares to a 6.3bp actual decline in the swap rate. The estimate hints that the 10y swap rate move today was slightly larger than it should really have been.