Reduce Risk After UK Recovery

• Over the past week, UK fiscal plans fully reversed, though this was not enough to save PM Truss. Markets welcomed the changes, with bonds recovering and policy spreads closing. Our higher forecast for UK inflation and lower EA inflation were realised.
• Next week risks a return of political headaches as candidates to be PM court their low-tax-loving selectorate. UK investors may wish to reduce risk for this process before reassessing opportunities after half term. Elsewhere, we still expect a 75bp ECB hike.

It’s been another tumultuous week in UK politics. Liz Truss started in office but certainly not in power. Alastair Newton highlighted its unsustainability as, to misquote Margaret Thatcher: “She can’t buck the politics” (see Trussonomics: You Can’t Buck the Market, 17 October). Things rapidly deteriorated on Tuesday as the home secretary jumped with a push out of the cabinet. Shambolic party management of a vote on fracking meant securing defeat from a successful outcome, as the government’s inability to conduct even regular business became clear.

Ms Truss recognised that she’d struggle to rule over even a bland platform rather than her own, so she resigned on Thursday. The contest for her successor is set to conclude by next Friday, bringing an abrupt end to the PM’s tenure in record time. Whoever wins is inheriting something of a poisoned chalice. They will preside over unpopular cuts without time in the election cycle to reap the fruits on the other side. Labour’s Keir Starmer will probably take over for that instead, with the question currently being more about the size of his majority rather than its existence.

Unfortunately, we struggle to see leadership swaps fixing the dismal long-term outlook. Economic underperformance and weak and fractured political ‘leadership’ feed on one another. Progressive hopes starve without money to fund it, even while libertarian dreams have died on the altar of Trussonomics. Conservative chaos will likely discourage internal Labour debates about its policy platform. Alastair Newton concludes that domestic politics over the past two decades must also shoulder its share of the blame for the current malaise. There seems little hope of this changing over at least the next ten years (see UK: You Thought Economics Was Dismal…).

Markets have enjoyed a boisterous week in the UK despite the political drama. It helped that the embattled government binned almost all its tax cuts and its policy platform. Most were reversing previous hikes, so some policies went full circle. Even the energy price guarantee is changing, with household energy prices surging for at least some in Apr-23. We hope the government will cap the units of cheap energy per household to avoid stoking inflation statistics and additional monetary policy tightening (see UK: Fiscal Oh-Turn).

Cancelling the fiscal stimulus reduces hawkish pressure on the BoE. Ben Broadbent explicitly recognised that while questioning “whether or not that response needs to be as large as the shift in market interest rates”. He warned that hiking that far would lower GDP by 5%, with three-quarters of that still to come (see our notes here and our archive of all speeches since 2007 here). Market pricing has reset in response, falling in line with our view for a 75bp hike in November, albeit with the cycle extending much further than our view.

The normalisation views we’ve been recently pushing have broadly earned their “easy wins”. The 30yr gilt yield is down about 1pp from its dysfunctional highs, near the end-September lows that followed BoE intervention. 2yr yields are also near their pre-Budget levels as BoE rate expectations have corrected even while US views have risen. The peak priced for the BoE broadly aligns with the Fed at 5% after the spread compressed another 60bps on the week to Thursday’s close. That level is 1pp above where we see the peak, but the UK-US spread is no longer unrealistic.

Fundamentally plausible relative pricings in the short end mean that the risk-reward on recovery trades looks significantly less attractive. Volatility clusters and is exceptionally high in this regime, so the potential drawdown is high relative to how much further these trades might run. That is itself a problem. Opportunistic investors may reasonably wish to lock in their gains from riding the recovery. Other active managers may want to reduce their risk for half-term holidays.

Unfortunately, recent events have damaged the UK market. High volatility means the risk associated with any given holding is higher, so the buying appetite is lower. That’s fine for the long end until someone tries to sell size into it. Attempting to do so will likely require a substantial concession that risks triggering others to sell again. It will take dysfunctional moves before the BoE considers bringing back its backstop. That might be over 100bps away on the 30yr gilt yield.

The BoE has at least recognised that it couldn’t sell into the long end of the market when it is this fragile. It will now only sell gilts evenly between shorts (3-7yr) and medium (7-20yr) maturities in Q4, with the maturity split reviewed ahead of Q1 (see market notice). We hoped it would postpone all purchases for longer so that the MPC might reassess the sales programme for its 3 November announcement. Pretending these sales will be fine for the year ahead after being blindsided by a crash within days of its launch seems incredibly optimistic.

Investors always need to position for policy as it is rather than what might be optimal. In this case, it means being prepared for problems in the QT programme and keeping a risk premium on 10yr gilts. Political posturing in the leadership contest is also threatening for longer maturities. Unless a consensus candidate is anointed the new PM or the second-placed challenger drops out, the conservative membership base will vote. It should not be news that the audience likes to be courted, like any electorate, and that this group favours low taxes. Mention of such things could trigger a bout of market PTSD.

Perhaps it’s safer to relax with less risk on holiday instead?! It should be easier and less stressful to weigh opportunities in a fortnight when volatility may have calmed more.

Meanwhile, on the data front, the hangover from Prime Day deepened to mourning in September as the UK returned to lockdown-like conditions by closing for the Queen’s funeral. This worse crash cut another tenth from our Sep-22 GDP forecast to -0.4% m-o-m but leaves Q3 at -0.5% q-o-q in our below-consensus call. October should rebound more. Unfortunately, the housing market may provide the next blow to consumers after surging inflation and rates. Its sharp slowdown looks like a stalling that could easily roll into a crash (see UK: Retail Mourns Funeral with Closures).

UK inflation separately returned to form by exceeding the consensus in Sep-22. The CPI matched our 10.1% y-o-y forecast, and the RPI was only a tenth above us at 12.6%. We see the supportive house price resilience ending imminently, but core pressures are also lingering at painfully high levels that push inflation persistently above the 2% target. We expect another rise in October inflation and a 75bp BoE hike in November (see UK: Core Raises Inflation Again in Sep-22).

EA HICP inflation went the other way, as Eurostat trimmed it to 9.9% in the final print for Sep-22. We expected this after Spain’s release last week, and yet the consensus was for no change. Underlying inflationary impulses remain sticky near their highs in many countries, while Italy is pushing new peaks. Food and energy will also support again in October. We are slightly above the economic consensus with flat rather than falling rates in the near term. The ECB will probably punch out another 75bp rate hike in response (see EA: Final HICP Trimmed at Excessive High).

We remain concerned about the potential for aggressive ECB action to concentrate problems in nations that can’t cope with them. The Transmission Protection Instrument does not seem up to the job of stabilising things before an emergency might force a response, where a truncated hiking cycle is likely to be part of that. A coordinated energy support scheme could help reduce those pressures building, but the European Council made little progress on that this week. It instead concluded with a pointed request for the Commission to essentially get a move on with its work (see European Council conclusions on energy and economy).

ECB Preview

The ECB was late starting its rate hikes when the economic state changed owing to difficulty winding down its promised asset purchases. It’s making up for that with an aggressive start to its hiking cycle that it signalled to continue alongside the announcement of September’s 75bp hike. The intended cumulative extent of that tightening was surprisingly small, though. In the ECB’s view, persistent spare capacity meant it only sought to get rates back to neutral over the next 3-4 meetings (see ECB: Leaping Towards Neutral).

We initially took that guidance (and the indication that 75bps would not be the norm) to mean a 50bps rate hike was most likely on 27 October. However, inflation worryingly surged beyond expectations in September (see EA: Inflation Burns Up Forecasts Again), despite the trimming in the final print. Low unemployment means both sides of the policy trade-off (demand and inflation) have pointed to a need for tighter monetary conditions, so we raised our call to 75bps.

ECB comments since then have consistently recognised the primacy of the inflation problem while acknowledging the mounting damage to GDP (e.g. Interview with Finland’s Olli Rehn). Germany’s Joachim Nagel explicitly connected that to policy – i.e. “with the high inflation rates, further interest rate hikes must follow”. Ireland’s Gabriel Makhlouf described rate hikes as “absolutely necessary” despite the possibility of a recession amid the risk of second-round effects. And Isabel Schnable ratcheted up the scale in a speech stressing “a strong case for a ‘robust control’ approach to monetary policy.” Overall, policymakers appear to be embracing the need to respond to inflation’s worryingly expanding overshoot rather than pushing back against it.

We expect the ECB’s three policy rates to rise by 75bps in response to these inflation pressures. It may ultimately seek to restore symmetry to the interest rate corridor, but there isn’t a pressing need to do that during the current dash towards neutral.

Returning to a two-tier system for paying interest is more pressing amid rapidly rising rates. The costs are painfully high and encourage keeping TLTRO-III drawings on deposit for the arbitrage spread. The ECB is in a relatively good position to introduce a tiering solution given its experience managing the problem in the other direction when it ran negative rates. Nonetheless, the SNB has already provided a precedent for doing it this way by announcing it on 22 September. Alternative approaches are possible, like netting off TLTRO funding. Still, a tiering system would address the broader problem, so it is likely to be part of the eventual solution even if not announced this time.

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