Shades of Fiscal Pressures
Flash PMIs for October extended the US outperformance to the UK and Euro area with more opposing moves and surprises. Such resilience sits uneasily with rate cuts. Modest rises in US unemployment suggest monetary policy is nearly neutral, but slight falls in Europe are more consistent with loose than excessively tight conditions. Slowing European supply growth is not disinflationary unless demand is even worse. Europe’s labour market resilience should not be discounted so much relative to the US (see PMI Shows Structural Over Cyclical Story).
Mounting hawkish evidence of global resilience was no discouragement to the Bank of Canada, which matched expectations by cutting 50bps to 3.75%. Inflation’s stabilisation near the 2% target was deemed to allow further easing to support demand amid assumptions of excess supply with the unemployment rate at 6.5%. It expects to keep cutting and is highly likely to do so, but expectations don’t always pan out. Indeed, the Bank of Japan had expected to keep hiking, yet that now looks unlikely in its meeting next week.
Despite the dovish Canadian result, there has been another significant rise in rates over the past week, partly owing to the resetting of Trump trades. However, excepting the Senate, the US elections remain finely balanced, offering four scenarios with a 20% or higher probability. Alastair Newton notes that among the four, a Trump administration would be better able to pursue his agenda than a Harris administration would hers (see US Elections: Four Scenarios). Markets may ultimately prefer gridlock again as a means to constrain fiscal laxity.
The political focus in the UK can arguably switch back to the domestic situation next week with the Budget on 30 October. Many policies are flying around because Labour floated more trial balloons than dropped at the Democratic National Convention, as a few too many party officials experienced first-hand after controversially joining that campaign. A substantial rise in borrowing and tax is set to fund more spending. The Chancellor has already warmed markets up for this after decrying an unaccounted £22bn Conservative overspend, which has risen to about £40bn in recent reports.
More issuance has been pressuring gilt prices in a reasonably regular way. We remain hopeful that conditions are unlikely to break from this into a dysfunctional regime despite changes to the fiscal rules. The rolling debt rule was already a poor budgetary constraint. There is also a reasonable case for not discouraging investment spending. We would be concerned if the new National Wealth Fund became a substantial slush fund for politically favoured projects. The new institutions aimed at ensuring value for money are unlikely to be any less pathetic than the old ones.
Outside the dysfunctional regime, gilt market participants should focus on issuance volume, with adjustments if necessary to capture gilt-like issuance. For example, suppose the National Wealth Fund or Great British Energy raises their funding through non-gilt branded bonds with a government guarantee. In that case, this supply should not be discounted from the market perspective of total issuance. The CGNCR, augmented for these other flows, remains the most relevant metric for gilt supply and pricing, irrespective of what jiggery-pokery the government attempts. That also applies to likely attempts to remove BoE QT costs from the fiscal space assessment.
Inflation Forecasts
Flash EA inflation for October remains likely to rise slightly, but we expect the extent to undershoot expectations by rounding up from 1.7% to 1.8% instead of reaching 1.9%. September’s disappointment helped push the ECB into easing even before its new forecast round. This outcome could raise dovish pressure again. However, with the market already pricing a substantial risk of a 50bp cut in December, it is arguably already priced for significant weakness. We still expect broader resilience, including in the EA labour market, to discourage the ECB from a 50bp cut.