ISM manufacturing survey surprises on the downside, UK govt. decides to retain top tax rate, driving big falls in global rates. Commodity currencies recover strongly

A weaker than expected ISM Manufacturing survey and a surprise U-turn by the UK Chancellor on the government’s tax package (retaining the 45% tax bracket after all) have driven a big fall in global rates overnight.  The US 10-year rate is almost 20bps lower, at around 3.65%, with similar-sized moves seen in Europe.  It’s been a case of ‘bad news is good news’ for equities which, after a miserable September, have put in a strong rally overnight, the S&P500 up around 2.5%.  Commodity currencies have rebounded aggressively from Friday’s slump amidst the recovery in risk appetite, the NZD now back above 0.57.  The NZ QSBO survey is released this morning while the RBA is expected to raise its cash rate by 50bps this afternoon.

The ISM Manufacturing survey for September was weak, the index falling from 52.8 to 50.9, its lowest level since mid-2020 and now teetering on contractionary territory.  The key New Orders and Employment components both fell back below 50 while the Prices Paid index edged lower to 51.7, a post-pandemic low and consistent with less inflation/cost pressure in the sector as supply chains start to normalise.  The issue for markets is that the inflationary baton appears to have been passed from goods prices, such as used cars, to ‘stickier’ services categories.

A major slowdown in manufacturing activity was always likely at some stage, as consumers switched spending back to services and away from goods.  The ISM Services index and the nonfarm payrolls report later this week will now take on added importance as investors try to judge whether the slowdown in activity is broadening beyond the manufacturing sector. The consensus is for relatively healthy readings on both, 56 for the ISM Services index and a 250k monthly payrolls gain.

The other key news overnight has been the abrupt (albeit not entirely unexpected) U-turn by UK Chancellor Kwarteng who announced the new government would retain the top 45% tax rate after all, bowing to pressure from markets, Conservative backbench MPs, and the general public.  Getting rid of the top tax rate, which applies to those earning over £150k, became symbolic of the new government’s seemingly misguided and out-of-touch policy direction.

The abolition of the top tax rate was never one of the more costly tax cut measures in the fiscal package (at an estimated £2-3b per year).  So, the broader picture, of a huge debt-funded fiscal stimulus likely to further inflame inflationary pressures, hasn’t really changed.  However, it does suggest the new government isn’t immune to pressure and with the Conservative party floundering in the polls (the next election is in two years’ time), the market may now put some weight on a further watering down of the fiscal stimulus in due course.

The combination of the downside surprise to the ISM survey and the U-turn by the UK government has seen a big fall in global bond yields.  The US 2-year and 10-year rates are both down 18bps overnight, the latter falling back to 3.65%.  Just last week, the US 10-year rate touched 4% for the first time since 2010 amidst the turmoil following the UK mini-budget.  The market still sees a high chance of a 75bps Fed hike next month (~75%) but pricing of the Fed terminal rate has come down to around 4.40%.  The UK saw a big ‘bull steepening’ of its yield curve, as the market figured less fiscal stimulus (and the recovery in the GBP) implies less need for an ultra-aggressive monetary policy response from the BoE.  The UK 2-year rate was 23bps lower, with the market pricing ‘only’ 120bps of rate hikes for the BoE’s next meeting in November, while the UK 30-year rate was 6bps higher.  Germany’s 10-year rate was 19bps lower, falling back below the 2% level.

It’s been a case of ‘bad news is good news’ for equities, with the market treating the downside surprise to the ISM index as increasing the chances of an earlier Fed pause, seen as positive for risk assets.  After sustaining heavy losses in September (S&P500 -9.5%, NASDAQ -10.5%), equities have rebounded strongly to start the new month, the S&P500 and NASDAQ both up more than 2% overnight.  The sharp rebound in equities also likely reflects a correction from extremely pessimistic levels of sentiment and very defensive market positioning.  Investors generally remain cautious given the Fed (and other central banks) are expected to continue aggressively tightening while corporate earnings are expected to come under pressure from the slowdown in the economy.

There has been plenty of noise about Credit Suisse over recent days (especially on Twitter), but this hasn’t spilled over into broader risk sentiment.  Credit Suisse’s share price slumped as much as 12% at one point overnight before recovering to close broadly unchanged.  The sharp slide in its share price this year, around -55%, is partly due to concerns the scandal-hit bank will need to raise fresh equity capital as part of a much-needed restructuring, diluting existing shareholders.  Despite the bank’s ostensibly very strong capital position (13.5% core-equity tier 1, substantially higher than banks were holding pre-GFC), Credit Suisse CDS has continued to track higher, hitting a new all-time high above 300bps overnight, reflecting underlying market nerves and likely hedging activity. Deutsche Bank CDS went through a similar situation in 2016 when it was similarly hit by several scandals and big regulatory fines.

The recovery in risk appetite has seen a big rebound in commodity currencies to start the week.  The NZD has essentially reversed its sharp fall on Friday, which took it deep into ‘oversold’ territory, and is back above the 0.57 mark, around 2% higher on the day.  The AUD and CAD are 1.7% and 1.3% higher respectively. UK Chancellor Kwarteng’s U-turn on the top tax rate has helped support a further rebound in the GBP, which is up almost 1% so far this week and now sits back above where it was before the shock mini-Budget two Fridays ago, at around 1.1275.  The EUR and JPY have been little changed, USD/JPY continuing to hover just below 145 despite the significant pullback in US Treasury rates.

Oil prices are higher off the back of weekend reports that OPEC+ is planning a big oil production cut, the region of 1m barrels per day according to the FT and Bloomberg, when the group meets in person in Vienna on Wednesday night.  Brent crude oil is up around 4% overnight, at around $88.50.

After all the recent volatility, the NZ rates market was very quiet yesterday with the Australian market closed.  For the RBNZ MPR tomorrow, the market is fully pricing a 50bps hike.  Terminal cash rate expectations have been pushing higher over recent weeks, currently sitting at around 4.80%, so the market thinks the RBNZ will ultimately need to take the OCR higher than its previous guidance of 4%/4.25%.  However, we should see a big fall in NZ rates when trading opens this morning, with the implied yield on the Australian 10-year bond future around 10bps lower than at the time of the NZ market close.

The RBA is expected to raise its cash rate by 50bps at its meeting this afternoon, which would take it to 2.85%.  The market will be focused on how the RBA couches the policy outlook given Governor Lowe has previously alluded to the likelihood that the pace of rate hikes will step down to 25bps increments at some point.  The NZ QSBO business survey is released this morning and is likely to highlight many of the same themes as the ANZ survey, namely sluggish growth indicators but still intense cost and price pressures.  NY Fed President Williams speaks this morning while his colleagues Daly, Logan, Mester and Jefferson are out speaking tonight.