The Asset Swap (ASW) curve in UK Gilts has recently steepened to levels not seen since early 2022. This move presents an opportunity to take a contrarian position by fading the steepening and positioning for a flattening of the curve. We outline why we believe this is the right trade and what factors will drive the anticipated shift in relative value.

Understanding the Current ASW Curve Dynamics

The ASW curve measures the difference in spreads between different maturities of gilts and their respective swap rates. Over the past few months, the steepening of the ASW curve has been driven by several factors:

1. Increased Fiscal Funding Requirements: The UK Treasury’s spring statement provided some clarity on government spending and borrowing plans. A significant portion of funding remains unallocated, and given increased borrowing needs, we expect the Treasury to allocate a large share of this funding to longer-dated gilts. This supply dynamic should weigh on long-end spreads, causing them to cheapen relative to the front end.
2. BPA Flow Activity from Insurers: Insurers have been relatively inactive in Bulk Purchase Annuity (BPA) flows year-to-date. However, once these flows pick up, there is likely to be an increase in demand for long-dated gilts, which could put downward pressure on long-end ASW spreads. This effect could be contingent on the trajectory of US credit spreads, as widening US spreads could dampen the appetite for long-dated UK paper.
3. Cross-Market Comparisons and Relative Value: The UK ASW curve has outperformed its European counterparts, making it relatively expensive. A reversion to historical norms could see a correction in the steepness of the 10s30s ASW curve, bringing it more in line with fair value.

Trade Recommendation: Selling the 10s30s UKT ASW Box

Given the factors outlined above, we recommend positioning for a flattening of the ASW curve by selling the 10s30s UKT ASW box. This trade benefits from:

• Increased Long-Dated Gilt Supply: With the UK Treasury likely to issue more at the long end, additional supply pressure should cheapen long-end ASW spreads.
• Rebounding BPA Flows: If insurers resume BPA flows, long-dated spreads could narrow, reinforcing the flattening trade.
• Market Positioning and Reversion to Fair Value: With ASW steepness at multi-year highs, a correction towards historical levels appears likely.

Risks to the Trade

While we have a strong conviction in the flattening thesis, there are risks to consider:

1. US Credit Spreads Stay Tight: If US credit spreads remain stable or tighten, the demand for UK long-end gilts may remain subdued, delaying the flattening move.
2. Unexpected Changes in UK Government Issuance Strategy: If the Treasury unexpectedly decides to allocate more issuance to shorter maturities, the supply-driven cheapening of long-end spreads may not materialize.
3. Global Risk Sentiment: In the event of a major risk-off move, there could be a flight-to-quality bid that keeps long-end gilts expensive relative to shorter maturities.

The current steepness of the UK ASW curve presents a compelling opportunity to position for a flattening move. Given the expected increase in long-end gilt supply, the potential resumption of BPA flows, and relative value considerations, selling the 10s30s UKT ASW box is an attractive trade. While risks remain, the balance of probabilities suggests a mean reversion in ASW steepness, making this trade a strong candidate for near-term relative value positioning.