Global rates ramp higher once again after strong ISM Services index, reports UK is planning huge debt-funded fiscal stimulus. Market back to pricing a high chance of a 75bps Fed hike later this month

There has been another big sell off in global bonds overnight with market reacting to a stronger-than-expected US ISM Services index and reports that new UK PM Liz Truss will unveil a massive fiscal stimulus later this week to protect households from rising energy costs.  The US 10-year rate has ramped 15bps higher, leading to another surge in the USD, to what is a fresh 20-year high on a DXY basis, and a modest fall in US equities.  USD/JPY hit 143 overnight while the NZD has made a new two-year low, now within striking distance of 0.60.  The GBP has outperformed, with the market seeing less near-term risk of UK recession and a higher-for-longer rates outlook in the UK. Yesterday, the RBA raised its cash rate by 50bps, as expected.  The Bank of Canada is next up to the plate, expected to hike by 75bps tonight.

The ISM Services index was stronger-than-expected, inching up to 56.9 in August against expectations for a fall to 55.3.  There was notable strength in the key New Orders subindex, which increased to a very healthy 61.8, while the Prices Paid subindex remained elevated, at 71.5, indicating still-strong inflationary pressures in the services sector, albeit not as extreme as a few months back.  The collapse in the lesser-followed Markit Services PMI for US, which fell to 43.7 in August, proved to be a bum steer on the direction of the US services sector.  Both the ISM Services and Manufacturing indices have trended lower over recent months but remain at healthy levels overall, indicating continued resilience (so far at least) in the US economy.

Global bond yields were already on the move higher before the ISM release and got an added jolt upwards after the data.  There have been some big moves again overnight, with the US 10-year rate 15bps higher, the UK 10-year rate 16bps higher, and Germany’s 10-year rate up by 8bps.  After some moderation in Fed rate expectations after Friday’s ‘goldilocks’ payrolls report, market pricing for a 75bps Fed hike in September is now back to almost 80% while pricing for the peak in the Fed Funds rate has shifted up to around 4%.  The increase to rate hike expectations has weighed on equities, although the moves have been reasonably modest, the S&P500 off around 0.4% and the NASDAQ down 0.7%.

Adding upward pressure to global longer-term rates have been reports that new UK PM Liz Truss will unveil a huge debt-funded fiscal stimulus package to cap energy bills.  Truss is expected to unveil a price cap for household energy bills alongside support for businesses later this week.  Bloomberg reported that Truss was planning to cap the average household energy bill below £2,000 for 18 months while the FT reported that the price would be capped at around £2,500.  On either option, Ofgem’s planned increase to the price cap for household energy prices from £1,971 to £3,549 in October would not go ahead.

The policy promises some near-term inflation relief.  Private sector forecasters had recently warned headline inflation in the UK could breach 20% but some are now saying, based on the energy price cap, that it may already have peaked at around 10%.  The policy will also reduce near-term recession risks by lessening the squeeze on disposable incomes.  But the policy comes at a huge cost, at an estimated £130b according to Bloomberg (~6.5%/GDP).  Combined with Truss’s other proposed fiscal policies, including cancelling the planned increase to corporate tax and cutting national insurance, the overall cost might be in the region of 9% of GDP, an enormous fiscal stimulus at a time when the UK economy is already at full capacity and headline inflation is around 10%.  This increases medium-term inflation risks and argues for a higher-for-longer UK rates outlook.

That has certainly been the market’s interpretation, with the UK yield curve experiencing a huge steepening move overnight.  The UK 2-year rate is 2bps lower, with lower near-term headline inflation expected to take a little pressure off the BoE to hike by 75bps this month, while the 30-year rate is 21bps higher, with the fiscal stimulus implying a stronger medium-term growth and inflation outlook and bond issuance likely to be ramped up to finance the plan.  There won’t be any support from the BoE for the bond market because it is now running down its large stock of QE gilt holdings.  The GBP has outperformed over the past 24 hours, unchanged on the day, just above 1.15, despite broad-based USD strength.

Europe is considering its own response to the energy crisis, with energy ministers set to meet on Friday night to debate a range of options.  Unlike the UK’s debt-funded stimulus, the primary option in the EU appears to be a windfall tax on energy producers, with the proceeds recycled back to consumers to buffer them from rising energy costs.  The FT reported the EU is likely to consider additional measures to cut demand, over and above the voluntary 15% reduction to gas usage previously agreed by EU countries, as well as assistance for energy companies struggling to meet margin calls on derivatives contracts.  The EUR is marginally lower overnight and briefly touched a fresh 20-year low, but it is back to around 0.99.  The immediate focus for the EUR is the ECB’s meeting on Thursday night, with the market expecting a 75bps hike.

The USD remains in the ascendency, reaching fresh 20-year highs on the DXY basis overnight.  The continued strength in the USD reflects the relatively stronger state of the US economy (certainly compared to Europe and China), the continued march higher in Fed rate expectations, and still cautious risk appetite among investors, given the lingering risk of recession next year.

The standout currency mover over the past 24 hours has been USD/JPY, which has catapulted up to 143 (+1.7%), a fresh 24-year high and now within sights of its 1998 peak of around 147.50.  USD/JPY remains highly correlated with US Treasury rates.  With the BoJ’s Yield Curve Control preventing the Japan 10-year rate from pushing above 0.25%, the increases in US Treasury rates are mechanically widening the US-Japan interest rate differential.

The NZD and AUD are both around 0.9% lower than this time yesterday, the NZD having hit a fresh two-year low in the process.  The NZD is now within striking distance of the 0.60 mark, trading this morning around 0.6040.  Weakness in the CNY has been contributing to the downtrend in the NZD and AUD.  USD/CNY has pushed up to around 6.9550, now closing in on the psychologically important 7.0 level, despite the PBOC’s efforts to slow the pace of yuan depreciation.

The RBA raised its cash rate by 50bps for the fourth consecutive meeting yesterday, as expected, taking it to 2.35%.  The RBA signalled more hikes were likely in the coming months but, in a change to the last statement, omitted its reference to “normalising monetary conditions”, a possible nod to the cash rate approaching neutral.  Our NAB colleagues think the change in language potentially foreshadows a slowing in the future pace of hikes to 25bps increments, depending on how the data unfolds.  RBA Governor Lowe is expected to provide more colour on the policy outlook in a speech tomorrow.  The market is pricing around a 40% chance of another 50bps RBA hike next month and around a 30% chance of the same in November.

It was a relatively quiet day yesterday in the NZ rates market, with swap rates less than 2bps changed across the curve.  Market pricing for the peak in the OCR has started to stabilise, around 4.35%.  This is above the RBNZ’s most recent projections, reflecting the market’s assessment that the balance of risks around the OCR over the next 12 months is to the upside.  Like the RBNZ, the market doesn’t fully price the first rate cut until the end of 2024.

Today sees the release of Australian GDP, with our NAB colleagues looking for a below-consensus 0.7% reading for Q2 growth.  Tonight, the Bank of Canada is expected to raise its cash rate by 75bps, a small step down from July’s super-sized 100bps increase, which would take the cash rate to 3.25%.  BoE Governor Bailey is testifying tonight while Fed Vice Chair Brainard is speaking about the economic outlook tomorrow morning.