UK announces big fiscal loosening on Friday night, prompting huge sell-off, reverberating in other markets. Broad-based USD strength sees EUR, NZD and Yen all fall. Markets brace for inevitable economic crunch

Markets have been extremely volatile since the NZ market closed on Friday afternoon.  UK bonds and the GBP have come under intense pressure since the release of the UK government’s free spending ‘mini-budget’. The GBP has collapsed ~5% in just two trading sessions, having hit a low of 1.0350 yesterday, while UK gilt yields have exploded higher, with the market pricing ~170bps (!) of rate hikes by the Bank of England by its next meeting in November. The volatility in the UK has reverberated to other markets, with all currencies weaker against the USD, rates continuing to head higher, and equity markets continuing to slide.  The NZD has made new lows against this stronger USD backdrop, dropping to 0.5630, over 3% weaker than it was on Friday afternoon.  We should expect another big move higher in NZ rates when trading resumes this morning.

Last week was a historic one for markets, with the Fed raising rates 75bps and publishing a hawkish set of interest rate projections, the Japanese Ministry of Finance intervening in the FX market to support the JPY for the first time since 1998, and a raft of other central banks implementing aggressive rate hikes of their own (Riksbank +100bps, SNB +75bps, BoE and Norges Bank +50bps).  It was a week where rates were much higher (US 5-year +35bps), the USD was significantly stronger (BBDXY +2.4%), and risk assets were sharply weaker (S&P500 -4.7%, Brent crude -5.7%) amidst mounting expectations that monetary policy tightening is going to crush the global economy.

Since we went home on Friday night, the UK has become the centre of attention for global markets.  On Friday night, new UK Chancellor Kwarteng announced a major fiscal loosening, amounting to the biggest tax reduction since 1972, at over 1.5% of GDP.  The range of tax cuts, including the removal of the top 45% rate of income tax, comes alongside the previously announced large-scale fiscal support for households and business to protect them from sky-high energy prices and could put the total cost of the combined measures in the region of 12-13% of GDP over the next two years on some estimates, an extraordinarily aggressive fiscal stimulus at a time when the Bank of England is confronted with CPI inflation of almost 10%.

The market response to the fiscal package has been an emphatic thumbs down.  UK government bond (gilt) yields have exploded higher, with the 5-year bond rate increasing a staggering 100bps in just two trading sessions, as the market anticipates greater inflationary pressures due to the fiscal easing and inevitably a more aggressive response from the Bank of England.  The GBP has crumbled, falling 3.5% on Friday and as much as 4.7% yesterday during illiquid Asian trading hours, hitting an all-time low of 1.0350.  It has since ‘recovered’ to around 1.0680, still 5% lower than Friday morning.  The GBP is also significantly weaker against other currencies, albeit less dramatically so than against the USD.  The EUR/GBP exchange rate is around 3% higher than Friday morning and is approaching the top of the range that has held for the past five years, while the NZD/GBP cross at one point pushed up to 0.55, although it has come careering back to 0.5280.

The simultaneous sell-off in both UK bonds and currency is more reminiscent of the experience of emerging markets than major currencies and suggests investors are attaching greater risk premia on GBP-denominated assets.  The UK already has a very large current account deficit (~8%/GDP) and soon-to-be extremely big fiscal deficit, meaning it will be dependent on foreign investors for funding (and higher rates / a lower GBP are means of making GBP assets more attractive to foreigners).  Additionally, the Bank of England is not going to be there to help absorb the bond supply this time – last week it agreed to start actively selling down its gilt holdings (£10b per quarter) which will add to the market’s net financing requirement.

While the Bank of England raised rates only last week, by 50bps, there had even been intense speculation overnight that it could announce an extremely rare inter-meeting hike, to try stem the weakness in the GBP and reassert its inflation-fighting credentials.  At one point overnight, the market was pricing 80bps of rate hikes before the next scheduled meeting in November.  However, BoE Governor Bailey released a statement overnight saying the MPC “will make a full assessment at its next scheduled meeting of the impact on demand and inflation from the Government’s announcements, and the fall in sterling, and act accordingly ”, implying it will wait until November.  The Governor’s statement has seen GBP fall around 2.5% from the intraday highs while the bond market hasn’t paid much attention, still figuring the BoE will ultimately need to raise the cash rate significantly over coming months regardless of whether it delays by another six weeks.

For context, the market is now pricing 170bps of hikes by the BoE by time of its November meeting (including 20bps of intermeeting rate hike risk) and a terminal cash rate of almost 6% (!) by mid next year.

The UK Chancellor has also put out a statement overnight to try reassure markets (without much success), saying the government would set out its medium-term fiscal plans in November and would (finally) get the Office of Budget Responsibility (OBR) to do an independent set of forecasts based on the fiscal measures.

The moves in the UK have set the tone for global markets, with further sharp increases in global bond rates and continued currency weakness against the USD.  The US 10-year rate has blasted up to a fresh high of 3.90%, around 20bps higher than it was on Friday morning, while the German 10-year rate is up around 15bps.  The yield on the Australian 10-year bond future is around 15bps higher than where we left it on Friday afternoon.

Equities have come under sustained pressure, the S&P500 down 1.7% on Friday and another 1% overnight, now set for its lowest close since late 2020 and some 24% off its recent peak.  The EuroStoxx 600 is down around 3% since Friday morning while the UK FTSE has outperformed, reflecting the significant portion of listed entities on the index have foreign denominated earnings, down 2% on Friday but unchanged overnight.  Oil prices have fallen 7% since Friday morning, Brent crude now trading near $84, with investors seemingly expecting a major recession off the back of the aggressive monetary policy tightening.

The weakness in the GBP has spilled over to other currencies, the EUR falling to a fresh 20-year year, now around 0.96, while the NZD has been caught in the downdraft, slicing below 0.57 overnight and now trading at 0.5630.  The NZD has fallen 3.5% since Friday morning, the AUD 3%, and the EUR 2.2%.  Meanwhile, USD/JPY has rebounded to near the levels where the Japanese Ministry of Finance intervened last week, back at 144.60.

The PBOC has taken further action to try to stem the weakness of the CNY, announcing yesterday a 20% reserve requirement on CNY FX forward sales to make shorting the currency more expensive.  Again, it has only served to slow the inevitable move, USD/CNY pushing up to 7.14 and USD/CNH to 7.17, now on the cusp of their highest levels since 2008.

Economic data have been significantly overshadowed by events in the UK.  The European ‘flash’ Composite PMI fell to 48.2 from 48.9, suggesting the European economy is already in the midst of a recession.  The US equivalent numbers, much less regarded than the longer established ISMs, fared much less badly, manufacturing up to 51.8 from 51.5 and services lifting to 49.2 from 43.7.

In Italy, a right-wing coalition of parties, including the Brothers of Italy, the League, and Berlusconi’s Forza Italia party won an outright majority of seats in parliament at the national election over the weekend, as foreshadowed by opinion polls.  Brothers of Italy leader Meloni, whose party won the most votes of the three coalition partners, has previously made the right noises about sticking to EU rules to gain access to lucrative grants from the EU Recovery Fund.  But investors are nervous about what direction the right-wing coalition might take the economy at a time when Italy has government debt to GDP of ~150% and is facing both higher bond rates and an impending recession. Add to that, ECB President Lagarde said overnight the central bank would consider shrinking its balance sheet once interest rates were “normalised”, which could be as soon as the end of the year, which would, in turn, imply even more Italy bond supply for the market to absorb. The Italy-Germany 10yr spread was 13bps wider overnight, now its highest since early-2020.

Friday saw wild moves in the domestic rates market, and we should expect more of the same today.  The 2-year swap rate was 13bps higher, hitting a fresh 14-year high of 4.66%, while 5-year and 10-year rates were higher by 16bps and 18bps respectively.  The market has lifted its expectation for the peak in the OCR to almost 4.75% by mid next year.  The market clearly thinks the inflationary impact from the sharp fall in the NZ TWI (~-4.5% this month alone) is likely to be a consideration for the RBNZ with its OCR settings. Liquidity has been very strained, exacerbating the size of the moves.

The UK is likely to remain the focus over the next 24 hours, including speeches by both Chief Economist Pill and Deputy Governor Cunliffe.  Outside the UK, there is a range of Fed officials on the speaker circuit this week while the key data release is probably the European preliminary CPI data (and individual countries ahead of it).  Headline inflation is expected to hit a new high of 9.7% y/y while core inflation is expected to rise to 4.9%, both way above the comfort zone for the central bank. Domestically, the main release of note this week is the ANZ Business Survey for September.