Market focus remains on the UK. BoE's Bailey talks tough publicly, not so much privately, causing some market volatility. Media reports that the UK government will U-turn on its fiscal proposals

Markets were perturbed by BoE Governor Bailey’s tough talk soon after we went to press yesterday, but some order has been restored as the market focuses on a likely U-turn by the UK government on the Budget proposals. After a wild ride, net changes in global rates are modest, US equities have spent much of the session slightly positive and net currency movements have been modest by recent standards. GBP shows the best recovery overnight, the NZD is trading around 0.56 while USD/JPY is on the verge of breaking 147.

The UK remains in the spotlight and a source of market volatility that has been spilling over into other markets. Soon after we went to press yesterday, BoE Governor Bailey hit the headlines, saying that his message to fund managers is ‘you’ve got three days left” and “we will be out” by the end of the week, referring to the Bank’s emergency gilt buying programme that is scheduled to end tomorrow. This triggered a notable risk-off move that sent the S&P500 down 1½% and the NZD down half a cent. More volatility was seen last night when the BoE had to reiterate that stance after the FT published a report saying Bailey had privately told bankers that the deadline for ending gilt purchases could be extended.

Bailey hasn’t done the BoE’s credibility any favours and you can almost 100% guarantee that the BoE would step in next week if UK markets became, or continued to be, dysfunctional – that is the job of a central bank. The UK 10-year gilt was as much as 20bps higher and the 30-year rate 30bps higher overnight, but both are now little changed on the day. The market was supported by the BoE’s largest bond buying under the emergency operation to date, with £4.56b purchased and no offers being rejected.

Some order being restored to the market has been helped by press reports that the UK government will backtrack on its proposed policies that have been a key factor in the market turmoil. Bloomberg reports current and former Cabinet ministers saying a U-turn is inevitable and will likely be announced at the Chancellor’s fiscal update on 31 October. The Independent reports that staffers have been told to undertake a line-by-line scrutiny on the fiscal proposals and the OBR’s workings to see if changes are needed and quotes “the turmoil in markets and the need to show fiscal prudence are being heeded…everything is being looked at again, including tax cuts”.

Monthly UK GDP data showed a 0.3% m/m contraction in August, making the UK on track to record a negative Q3 outcome, likely the beginning of a well-anticipated economic recession. In other key economic news, US PPI inflation offered little respite from the strong inflation narrative, with the headline rate stronger than expected at 0.4% m/m and 8.5% yoy, boosted by higher food prices, while core inflation was broadly in line at 0.3% m/m and 7.2% y/y. Key US CPI data are released tonight.

The US earnings season kicked off with a strong result from Pepsico and an upgraded outlook. The strong result reflected price increases put through that exceeded costs and this more than offsetting weaker volumes – not good for those worried about “stagflation” but good for Pepsico if it has pricing power. It’s early days and the earnings season is bound to throw up some nasty surprises.  The S&P500 has spent most of the session in positive territory and but currently shows a small loss.

The US 10-year Treasury has oscillated in line with UK rates, rising to just under 3.98% overnight, falling back below 3.90% and currently 3.92%, little changed on the day.

In currency markets, GBP has shown plenty of volatility again, gaining 100pips from 1.095 to 1.105 after the FT reported that Bailey had privately told bankers that the emergency gilt buying programme could be extended, and reaching almost as high as 1.11 in recent hours. EUR initially moved higher in line with a stronger GBP but has since retreated and is back below 0.97.

Against a more settled market backdrop, the NZD recovered back above 0.56 and currently sits close to that mark. The AUD has largely tracked sideways, oscillating around 0.6265, helping NZD/AUD push modestly higher to 0.8940. BoJ Governor Kuroda reiterated that the Bank must retain its ultra-easy policy stance, wage increases being necessary to achieve its inflation target. The market is testing where the next level of FX intervention will be and there hasn’t been any obvious yen buying activity from the MoF as USD/JPY climbs to fresh 24-year highs just under 147.

The domestic rates market showed only small changes, against a backdrop of more order returning to the global rates market. NZGB yields fell slightly, while swap rates were mainly slightly higher across the curve, apart from the short end, with the 2-year rate down 1bp to 4.86%. There was no reaction to another bleak housing market report from the REINZ, with house sales at historically depressed levels, normally associated with economic recession, and house prices continuing their steady grind lower, the nationwide index now down 12.6% from the November 2021 peak and plenty more downside in the pipeline.

In the day ahead, the US CPI will be the main focus, where the consensus expects to see annual headline inflation moderating to 8.1% and core inflation increasing to 6.5%.  Unlike last month, where the market was positioned for a low print, recent price action suggests that the market is more accepting of another high print.  A surprise in either direction has the scope to cause a significant market reaction.

As we go to press the FOMC minutes of the September meeting have just been released. The key headlines are that the consensus was to “purposefully” move to restrictive stance in the near term, though several officials saw it as “important to calibrate” the pace of tightening to minimize harm to the economy. And many officials saw the need to maintain restrictive rates for “some time,” with several saying such a stance could be held “as long as necessary”.