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“No alarms and no surprises“?

Radiohead, No Surprises

Last week, we discussed the latest iteration of US Monetary policy and the Fed’s latest projections for the interest rate path and the evolution of economic activity, labour market and inflation. We argued that the overall tone of the statement, the hawkish communication and the well behaved economic data suggest that we are moving towards a narrowing of the distribution of possible terminal rate paths. Thus, in many respects, we are a step closer to fully pricing the Fed reaction function and the extent of the monetary tightening cycle. With housing markets slowing, headline inflation peaked, the global economy slowing and global central bank tightening, outside the Fed, beating the 125bps priced into the Fed dots feels like a pretty tough ask. If, as we suspect, inflation starts to fall, as we move into Q4, it becomes even more so.

We even proposed the possibility that the Fed had forecast a rate path that was ‘one step beyond’ the ultimate terminal rate - a proposition that admittedly has not been immediately evident in market price action this week, but is still a view that we feel has merit. As has been the (seemingly continuous) case for 2022, we have subsequently seen a chain of new and unforeseen events that have generated further volatility and uncertainty in Fixed Income (FI) markets and for the global macroeconomic backdrop. This time, the volatility has centred a little closer to home.

No sooner had we pressed ‘publish’ on our thoughts for last week, than the landscape changed once more. As markets, exasperated and exhausted from an incredibly hectic week of central bank watching, rate repricing and (both inflation and growth) risk repricing across all asset classes, thought the action was all but over for the week, UK Chancellor of the Exchequer stood at the despatch box.

The Chancellor’s intention was to deliver the “biggest package in generations” of tax cuts to send a clear signal that the core priority of the new government is economic growth. The measures consisted primarily of tax cuts and simplifications, with (i) the removal of the 45% additional rate tax band for those earning above £150,000 alongside other tax simplifications for the self employed (ii) the bringing forward of a cut in the basic rate of income tax, from 20% to 19%, to April 2023, (iii) the confirmation of the leadership campaign pledge of the UK Prime Minister to reverse the 1.25% national insurance rise introduced earlier this year - cancelled from 6th November, (iv) cancellation of the proposed corporation tax increase from 19% to 25% and (v) changes to the stamp duty thresholds aimed at the lower end of the property market and at first time buyers.

From my perspective, the intentions of the new chancellor were clear - to expand the supply side of the economy through tax cuts to target economic growth (of 2.5% a year). Some measures, such as the 45% tax rate, drew significant political (and apolitical if the IMF can be counted as such) criticism. However, it was clear from the data that the lowering of the top rate tax band from 50% to 45% in the UK increased, not decreased the tax take - so it is not obvious that this is a regressive measure. The corporation tax (remaining at the lowest rate in the G20) is clearly aimed at attracting and retaining global investment and promoting a “virtuous circle of growth”. Stamp duty changes, tax simplification and the reduction of the basic rate will also act to stimulate growth through respective channels.

The (not so) mini-Budget did, however, come hot on the heels of the PM’s announcement that the taxpayer would ultimately cap the price of household (and subsequently business) energy bills for the next two years - an inefficient and potentially very expensive solution that does not attempt to address or restrain demand; it was nonetheless likely the only option in one form or another (indeed, it has been replicated by and large across those countries most affected by the gas price spike). This can be viewed as ‘A (very) big short’ on the Natural Gas market, as we have previously discussed.

Herein lies the issue. While the starting point was a government with the second lowest debt to GDP ratio in the G7, the very rapid (and importantly, unfunded - i.e. not matched with spending cuts) fiscal expansion in a country with a very large Net International Investment Position (NIIP), likely means that the basis under which global investment to bridge the deficit is financed must adjust. Essentially, this means a lower exchange rate or a higher rate of interest. On Friday, shortly after the fiscal event, we got both higher rates and a lower GBP. Essentially, the market is questioning at what level of gilt prices and at what exchange rate it can continue to fund the external deficit.

The IMF highlighted the issue earlier this week, stating “It is important that fiscal policy does not work at cross purposes to monetary policy”. Indeed, sell side analysts went even further in their criticisms and prophecies of doom for the UK. Late this week, when the Bank of England stepped in to buy long end gilts and delay the active QT sales until the end of the month (at least), the (hysterical?) commentator narrative was talk of YCC and bond market intervention. The argument that intervention both lowers nominal rates, raises inflation expectations, and real rates are negatively impacted through both channels and thus GBP is undermined - is a fair theoretical assumption if you consider it intervention to lower interest rates. From my perspective, it was the Bank stepping in to provide liquidity to a market that had become disorderly (pension fund margin calls exacerbating a move in thin liquidity)

BoE Chief Economist: “Gilt buying not an attempt to cap rates”

Theoretically, the resolution to the issue of fiscal concern for the UK comes through a weaker currency and higher yields to recompense the global investor in the UK for the deterioration in the public finances, OR, a reduction in inflation (pushing real rates higher) and an improvement in the growth backdrop of the UK having a similar effect. However, the real issue was likely not the size of the fiscal intervention, nor ultimately the unfunded part (the full package broadly fit within market expectations of further UK fiscal expansion). Rather it was communication: the fact that the Chancellor did not commission an OBR review to convince markets that debt to GDP would still fall over the medium term; that will now come in November.

In the UK, there is a saying - ‘people who live in glass houses shouldn’t throw stones’. I can’t help but think it is a bit harsh for the market to single out the UK in terms of debt / fiscal stimulus / inflation when the rest of the world is far from void of criticism in this regard. It is true that the new Chancellor made an error in not publishing or commissioning an independent review of the fiscal implications and or communicating the commitment to fiscal prudence in announcing his (aspirational) fiscal plans. I fully expect that the government, given where they stand in the polls at the moment, to announce intended spending cuts in the next parliamentary session and maintain the push for growth - likely their only way to remain in power come 2024.

The unknown, and likely critical factor for GBP, UK rates, UK finances and ultimately the economy is the inflation tradeoff. How does the fiscal stimulus interact with significantly higher rates and likely declining global aggregate demand in the evolution of inflation? We know that the base effects of commodity induced inflation will begin to turn sharply over coming months. Furthermore, the state of the UK public finances will also be very sensitive to the FN future - or the UK benchmark natural gas future - where there is a direct impact on government finances to the rolling settlement.

We will likely get further bouts of acute volatility, and there will be increased scrutiny on the fiscal outlook (although you could argue that credible cost cutting measures going forward would be a positive surprise), not to mention on the inflation and growth data. From a monetary policy perspective, the focus will be on November and how the BoE view the inflation trajectory in relation to the offsetting impact of fiscal expansion vs. a rally in yields and the decline in the pound. However, meeting market expectations on both November rate hike and terminal rate expectations are a big ask, given the caution with which the Bank has approached the economic uncertainty to date.

Ultimately, while many commentators fell over themselves to declare a GBP crisis, I am yet to be convinced. The UK will certainly have to endure significantly higher interest rates for the foreseeable future, at least while the threat of inflation persists. It is, however, very likely that going forward the new Chancellor will heed the warning of Radiohead and offer "No Surprises" as far as fiscal announcements are concerned

But as we move into Q4, we are more inclined to expect markets to question the amounts priced into rate hike expectations - even in the US - as the global economy slows. We would also argue that the fate of the USD is more significant in the fortunes of the pound than the current fiscal expansion, and from our perspective, the USD outperformance is drawing to a close.

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