Picture by Kirsty O'Connor / HM Treasury.
Analysts at NatWest see the Pound being supported by the Bank of England's policy shift and think bond market pressures should remain contained.
Talk about rising borrowing costs in the UK is doing the rounds again after the long-term 30-year bond yield rose to its highest level since April, beyond which levels last seen in 2018 beckon.
"Jitters over inflation and public finances lift the 30-year UK government bond yield to levels last seen when Geri Halliwell walked away from the Spice Girls," writes the Times in Tuesday's edition.
The rising cost of borrowing is unhelpful for Chancellor Rachel Reeves, as she will need to pay more to borrow over the long term.
"UK fixed income came under pressure yesterday afternoon with Gilt and swap yields rising roughly 5bp across the curve and the 30Y linker rising to the highest level since 1998. While yields had steadily climbed throughout the day, the move gained traction during the late afternoon," says Frederik Romedahl, Chief Analyst in FI Research at Danske Bank.
Typically, the Pound rises alongside bond yields as foreign investors look to snap up a higher-yielding asset. But we saw no meaningful lift for the currency against any of its major peers on the day.
During periods of heightened fears over UK public finances, the Pound can move in the opposite direction of yields, as was the case under Liz Truss and has also happened on a number of occasions this year.
Economists warn the UK's debt burden will be in the spotlight again when Chancellor Rachel Reeves delivers her Autumn Budget, affording the Pound a calm summer, but a risky year-end.
However, analysts at NatWest are more optimistic about the Pound's prospects and reiterate a view that the Pound should stay supported.
NatWest says the Bank of England is central to a constructive view on Pound Sterling, as it will soon shift strategy on quantitative tightening and help alleviate long-dated bond market stresses.
Quantitative tightening is the programme of selling back its holdings of government bonds as it unwinds its pandemic and crisis-era purchase of bonds made under the quantitative easing programmes.
Of course, selling bonds into a tight market only increases supply, lowering the bond's price and raising its yield.
This is unhelpful for the government at a time of falling demand for long-dated bonds, as they are deemed more risky in times of rising inflation and surging government borrowing.
But NatWest thinks the Bank of England will take into account the possibility of market stresses and will cease active bond sales beyond September.
"If we’re right, then this should ease some pressure on the long-end. At the margin, this points to a smaller risk premia applied to Sterling because of reduced fiscal concerns. The currency has had a negative correlation with long-end rates," says Paul Robson, FX Strategist at NatWest.
Above: The 30y bond yield.
Furthermore, NatWest thinks the Bank of England's recent policy update points to less interest rate cuts ahead, which should bolster short dated UK bond yields, which are arguably more relevant to the Pound.
"We hold to our 1.40 end’25 GBP/USD call and see value in positioning for EUR/GBP weakness," he adds.
The Pound to Dollar exchange rate has recovered through August as markets account for fewer interest rate cuts, rising from lows at 1.3150 to the cusp of 1.36.
The Pound to Euro exchange rate has risen from 1.1450 to 1.1600.
"The August BoE MPC meeting clearly provided another test of dovish market pricing, both in terms of the pace at which Bank Rate is expected to reach terminal as well as the ultimate landing zone of policy in the current easing cycle. It plays Sterling supportive, in our view," says Robson.