Wake me up when September ends

Interest rate expectations jump again

For the second consecutive time – and for only the second time since it became independent – the Bank of England increased interest rates by 50bp in September. But the Monetary Policy Committee (MPC) was split on the decision: three members backed a 75bp increase; five voted for 50bp; one backed a 25bp increase. The Committee did, however, unanimously agree to Quantitative Tightening (QT) of £80bn over the next twelve months, which will include passive QT (not re-investing the proceeds of maturing assets) and active QT of around £10bn of sales per quarter. Recent data on the UK economy has not been positive, with poor retail sales and consumer confidence figures persuading a number of MPC members to opt for a 50bp increase rather than a 75bp increase. Moreover, the announced energy price cap has dramatically lowered the projected peak of inflation, which is now expected in October as opposed to the end of the year. This energy price cap has improved the short-term economic outlook resulting in the bank feeling less pressure to front-load rate increases.

September’s fiscal statement by the Chancellor will now mean the Bank of England adopts an even more vigorous monetary policy. In its recent MPC statement, the bank argued that announcements were likely “to contain news that would be material for the economic outlook” – and, indeed, there were a series of fiscal loosening measures in areas including national insurance, corporation tax and stamp duty which, according to HM Treasury, will cost the exchequer nearly £45bn a year by 2026-27. This, of course, excludes costs associated with the temporary energy price cap. The initial market reaction to the Budget was not encouraging: the pound tanked against the dollar and 10-year gilt yields rose by around 100bp over the course of three days trading, and particular issues surrounding the pensions industry and long-dated gilts led to an intervention by the Bank of England to prop up the market. We will be discussing this in more detail in next month's wrap.

The weakening pound and tight labour market – followed by the negative reaction to the fiscal statement – are prompting markets to price in rapid increases to interest rates. At the time of writing, markets now expect interest rates to be around 5.5% in mid-2023. If interest rates were to reach anything like these levels, there would be a severe impact on UK economic growth prospects as well as a likely correction in the property market. 

Prior to the fiscal event on 23 September, there were already a number of factors weighing on the minds of MPC members. The latest employment data highlights a UK labour market that remains very tight, with inactivity around 650,000 higher compared to pre-pandemic levels and unemployment registering at just 3.6%. This clearly has the potential to spur on wage growth which is rising in nominal terms, although not for the moment in real terms. And, of course, other central banks are continuing to implement considerable rate increases, including the Federal Reserve's recent 75bp hike. The US's core rate of inflation saw an unexpected jump in August, and the Fed itself has made it clear that the tightening cycle is far from over. MPC members will be mindful of the impact this could have on sterling, which has already seen major falls in recent weeks: in advance of the fiscal event, the British pound was roughly 7% down against the US dollar since early August and the pound's effective exchange rate was down by roughly 4% over the same time period. A weaker pound will, of course, have an inflationary impact given the UK's high import-dependence.

Central Bank bonanza

I noticed that Cam had started the July wrap with the line “It has been without doubt a whirlwind of a month” that would be an understatement for the month we have just had!

It was always going to be a month of market movements as we had policy meetings from the ECB the Federal Reserve and the Bank of England. First to report was the ECB, economist estimates were mixed; in fact two economists that report to Bloomberg suggested that the ECB would leave rates unchanged. Markets were pricing between 50 and 75 basis points. The ECB did in fact decide to raise rates by 75 basis points, the largest amount since the start of the monetary union, and made it very clear that it was fully determined to do more. This confirmed that the central bank had given up on inflation targeting and forecasting, and was instead focusing on bring down actual inflation. One could argue that raising interest rates cannot bring down inflation that is mainly driven by external factors, and any near-term recession will more likely be caused by energy prices than interest rates. At the news conference after the decision ECB President Christine Lagarde’s comments implied that the bank is determined to bring interest rates to their neutral level of around 2%. Inflation in the Euro area surprised again to the upside in August as the headline rate reached 9.1% from 8.9% in July. The surge in gas prices continues to pass through to consumers and price pressures are becoming more broad-based. Headline inflation was again higher than expected in September as year-on-year inflation rose to 10%.  Markets are close to fully pricing another 75bp in October.

Next up was the Federal Reserve; it too hiked the Fed funds target range by 75 basis points in what was a unanimous decision. In the days before the meeting, markets had positioned for a potential 100 basis point rise. The Fed met economists’ expectations with the 75 basis point rise, with inflation the number one enemy, the Fed repeated that it needs to see a much larger slowdown in activity and left the door open for a fourth consecutive 75 basis point rise in November. As inflation remains elevated due to supply and demand imbalances and broader price pressure, this is looking more and more likely. US Inflation data had surprised markets with a lower than expected number in July and it appeared that traders were hoping for more of the same in the August figure but instead it was higher than expected. Inflation excluding food and energy rose 0.6% month-on–month, well above the 0.3% expected by economists, which caused a huge rally in the dollar and pushed interest rates nearly 20 basis points higher.

With the ECB and Fed both increasing rates the sterling curve was also marginally higher after the former’s announcement, and about 10 basis points higher after the latter. Expectations from  economists were that the UK base rate would be increased by 50 basis points whilst the markets had nearly fully priced in 75 basis points. With the exception of employment numbers, data from the UK prior to the meeting had all been disappointing. Monthly GDP was lower than expected along with manufacturing and industrial production. Even CPI was slightly lower and retail sales were dreadful. The announcement of a 50 basis points rise did not do much to swap rates. They initially sold off and then rallied back to close about 10bps on the day. 

‘Mini-Budget’ chaos

It was the ‘mini budget’ on Friday that really spooked the market. After the announcement from the chancellor, rates spiked and closed the day around 50 basis points higher. Things were only to get worse on Monday morning during the Asian trading session, which admittedly is a very thin market for cable, when the pound hit new lows of 1.0350 before rallying back to above 1.0800 before the end of the day. Interest rates jumped at the open and traded 50bp higher in 5 year swaps.

We can safely say that this month, due to fiscal sustainability worries and the loss of confidence in both sterling and sterling-denominated assets, has been a really bad one for gilts. One concern is the policy cooperation between the BoE and the Treasury. Markets perceive that the two institutions in charge of economic management in this country are at cross-purposes. It will take some time for investors to regain their appetite for gilts after the recent volatility. The announcement that the Bank of England is resuming gilt purchases was obviously an acknowledgement that the market was experiencing distressed trading conditions and the bank increasing its stock will help towards easing things. 30-year gilts, which the bank is planning to buy, had reached their highest yield since 1998 before the announcement, only to drop the most in history afterwards. The longer end of the gilt market is not usually the centre of attention as it tends to be the more stable. However, with pension funds facing margin calls as the gilt market sells off, the bank could be forced to post additional collateral and to sell more which could then become a vicious cycle. 

The language accompanying the announcement was also interesting to note: “The purchases will be carried out on whatever scale is necessary,” the central bank said, which was reminiscent of ECB President Mario Draghi’s 2012 pledge to do “whatever it takes” to save the euro. All considered, the Bank of England will probably need to continue the purchase of gilts far longer than the two-week period mentioned.

In a week where the government unveiled the biggest tax cuts in half a century, the pound has plummeted to its lowest level ever against the dollar, the cost of insuring British government debt against the risk of default has soared to the highest point since 2016, and the Bank of England has been forced to intervene to support the nation’s pension funds. The key now is whether Liz Truss’s barely month-old administration can restore its credibility with investors. Ms Truss made the tax cuts her centrepiece for her programme for government. The ‘U turn’ by the chancellor to remove the 45% tax threshold may have helped sterling in the short-term, but it is becoming increasing clear that she could struggle to push through key parts of her economic plans for Britain. The public is dubious that her gamble on ‘trickle-down’ economics will pay off, and there are some senior financial figures who are also not helping her cause. Alan Monks, an economist at JPMorgan Chase & Co. in London said the markets “aren’t willing to trust the Truss administration’s claims that it will deliver medium-term fiscal sustainability on the basis of its word alone. That  reflects a broader distrust in markets about how UK policy making has been evolving  and in our view, that distrust is entirely justified”. Berenberg Bank’s Kallum Pickering also said: “Because the UK has damaged its once-strong credibility with a poorly-managed Brexit and persistent threats of a UK-EU trade war, it no longer enjoys the benefit of the doubt”. One thing for sure is we can expect more volatility in rates markets and FX in the near future.

Charlie Neil, Capital Markets

All data in this article, unless otherwise stated, is sourced from Bloomberg