There’s ample scope for volatility in the upcoming week, although that’s not saying much. There’s been ample scope for volatility seemingly every week this year.
UK politics will remain in focus, which is somewhat vexing. In my experience, market participants generally dislike UK politics and even those who don’t have surely had enough by now. When Liz Truss resigned after just six weeks on the job, she was the least popular prime minister in history, according to YouGov polling. With a net favorability rating of negative 70, she was polling 17 points lower than Boris Johnson’s worst score, registered just prior to his own resignation in July.
Rishi Sunak will likely prevail in the leadership race. Boris dropped his bid late Sunday. Penny Mordaunt seems a long shot. Whoever wins will inherit a broken bond market, a fragile currency (figure below), an economic crisis and a political mess of historic proportions. Voter support for the Tories has never been lower. The party was described this week as being on “life support.”
Although Truss’s resignation was most assuredly welcome news for irritable markets, this isn’t a “forgive and forget” sort of deal. It’ll be a while before the pervasive skepticism her growth plan fostered wears off. Inflation is double-digits, the Bank of England still intends to move forward with gilt sales beginning on November 1 (albeit in a manner calibrated to protect against long-end volatility) and notwithstanding official pushback on terminal rate pricing, Andrew Bailey is condemned to outsized rate hikes, which risk prolonging the UK’s bout with stagflation.
The abandonment of Truss’s growth plan does mean less issuance, but given the sheer amount of uncertainty in the political arena, markets aren’t likely to afford UK assets the “credit” they deserve for Jeremy Hunt’s commitment to discipline. Apparently, Hunt is now pondering £20 billion in tax hikes for the medium-term fiscal plan due later this month. We’ve come a long way from the Kwarteng budget.
“Our economists estimate the UK government’s fiscal policy U-turns would translate into a £130-140 billion reduction in gilt issuance over the next four fiscal years [but] with political uncertainty still elevated, the market may yet discount the total fiscal improvement of the current budget plan,” Goldman said. “Over the next year, the reduction in fiscal support — particularly through a pared-back energy price guarantee — will worsen the trade-off between growth and inflation in 2023.”
Meanwhile, the ECB is set to deliver a second consecutive 75bps rate hike. “The hawks have clearly convinced the few doves left of the necessity to go big again,” ING’s Carsten Brzeski said, noting that “contrary to the run-ups to the July and September meetings, there hasn’t been any publicly debated controversy on the size of the rate hike.”
The assumed three-quarter point move would still leave rates laughably short of headline CPI. Neutral is somewhere in the neighborhood of 2% (I guess), but as I’ve argued extensively in these pages, inflation is largely out of the ECB’s hands. Everything depends on the evolution of energy prices, the success of the bloc’s plans to contain them and, relatedly, the war in Ukraine, where Russia again took aim at civilian infrastructure over the weekend. Market pricing for the terminal rate exceeds 3% (figure below).
I’d be remiss not to remind readers that the ECB is still haunted by an ill-fated rate hike into the teeth of a burgeoning recession 14 years ago. If, as I believe, rate hikes aren’t likely to be the deciding factor when it comes to inflation outcomes in the eurozone, hiking in line with market pricing for the terminal rate could be remembered as a policy mistake of potentially epic proportions.
The ECB “likely wants to hike rates to neutral by December and then be more flexible on hikes while preparing QT,” SocGen wrote, adding that the bank “may also decide to alter the terms of outstanding TLTROs or change the way it remunerates banks’ excess reserves.” The QT discussion is premature. Christine Lagarde probably wants to get to neutral first, and besides, recent fireworks in gilts which forced the BoE back into bond-buying will likely be viewed at the ECB as a cautionary tale.
“There has been broad pushback against the notion that an economic slowdown, or even a recession, would have a significant impact on the inflation outlook,” TD said, in their ECB preview. “Therefore, despite the growth outlook for the euro area continuing to deteriorate, headline inflation surprising to the upside should put further pressure on the GC to hike by another 75bps.”
Also on deck: The Bank of Japan and the Bank of Canada. Canadian inflation surprised to the upside in September, data released last week showed. That piles more pressure on Tiff Macklem to go big. Again. Last month, Macklem hiked 75bps, which counted as a downshift. In July, the BoC fired a 100bps cannon at inflation, with little to show for it. “We look for the BoC to lift its policy rate by 75bps in October due to stubbornly broad and persistent underlying inflation,” TD said. The bank expects another 25bps move in December and a terminal rate of 4.25%. “Rapidly slowing growth will warrant a pause in the new year,” chief Canada strategist Andrew Kelvin wrote.
As for the BoJ, what can you say? Japan intervened again on Friday to put the brakes on the yen’s ongoing slide, and while it was effective, it doesn’t change the fundamentals and Haruhiko Kuroda isn’t about to change his mind on the necessity of seeing a durable change in wage growth dynamics prior to any policy shift.
The country notched a 14th consecutive trade deficit in September (figure below), which is both a cause and a consequence of the weaker currency.
The yen’s never-ending slump is driving up Japan’s import bill, and the longest streak of red ink in seven years just makes the case against the currency that much stronger.
At the heart of the problem is Kuroda’s insistence on the preservation of the 0.25% cap on 10-year JGB yields, which he was forced to defend last week. Buying bonds is tantamount to easing, which adds to pressure on the yen, and capping yields means rate differentials will move against the currency on any day when 10-year US yields are rising and Japanese yields are at or near the cap.
Everyone knows it’s unsustainable, but at the same time, it’s not obvious what the alternatives are. For those interested in the long version, I’d encourage readers to review “Breaking The Bank.” If you just want the short version, Goldman’s Kamakshya Trivedi summarized the situation in a Friday note:
JPY took another hard round-trip on Friday after another apparent large-scale intervention. On the one hand, Japan’s current policy mix is clearly unsustainable; it is intervening in both the fixed income and foreign exchange markets, firmly entrenched in the classic “open-economy trilemma.” But, while ultimately unsustainable, it is “working” to some degree. The yen’s beta to US rates has fallen since the first intervention operation, and repeated intervention steps will likely keep it that way for a while, in part by inducing two-way volatility into USDJPY. While suboptimal and unsustainable in the medium-term, we think this policy mix could be in place for some time. After all, the extent to which the end of the BoJ’s YCC policy will strengthen the yen will depend largely on the exact strategy that is chosen to replace it. And it is probably appropriate for the BoJ to maintain a much easier monetary policy — inflation is picking up but underlying trends are still soft (our economists expect YCC to remain in place at least through the end of Kuroda’s term, and potentially much longer). Most importantly, the dollar is currently on a broad appreciation trend of historic proportions, which we think could last a little while longer. So it may not be unreasonable for Japan’s policymakers to use the resources at its disposal to try to buy time and limit the speed of JPY depreciation as much as possible.
Kuroda isn’t expected to budge this week. Inflation in Japan hit 3% in September for the first time in decades if you don’t include the spike eight years ago around tax hikes.
On Sunday, Prime Minister Fumio Kishida told reporters that Japan “remains on high alert toward the foreign-exchange market, and will take appropriate actions against excessive moves.”
The First World sure does seem to have a lot of Third World-style problems these days.
I wonder how much leverage there is in the Japanese pension complex…