Hawks Don’t Tire Easily

• Over the past week, markets were reminded that the Fed still wants to squeeze the economy. Meanwhile, high inflation and government emboldening of second-round effects show the UK still needs tightening, as does the EA, despite the revised HICP.
• Next week is much quieter for data, with the flash PMIs for November a clear highlight. The success or otherwise of Black Friday sales is another critical event, but that is rarely immediately apparent. The BoE’s Thanksgiving gilt sale is a slight risk.

The fallout from the US CPI’s rare downward surprise had previously helped push a significant loosening of rate expectations. Indeed, it went to the extent that we suggested it was “time to draw a profitable line under this narrative for the time being”. The risk-reward was no longer worth it, given the upside skew to the likely outlook, especially with our (correctly) way-above consensus UK inflation forecast.

Markets have retraced some of that move over the past week, with US and UK policy pricing up by about 15bps into Thursday’s close. Bullard’s hawkish comments about how far rates may need to go provided a timely reminder that one data point is not enough for central banks to declare victory over their inflation problem. Nor has enough gap opened between our forecast and the market to make the relatively dovish alternative an enticing trade again.

There was also some more news on the US political front, as the Republicans officially crossed the line to take control of the House, as expected. Alastair Newton looked beyond the immediate results towards the upcoming Presidential race. He argues that Ron DeSantis still has a long way to go if he is to beat Donald Trump for the Republican Party’s 2024 nomination, despite his strong performance in Florida’s gubernatorial election. However, one way or another, Trumpism is alive and well (see US Politics: Trumped? ).

In the UK, conservatism is suffering a prolonged death rattle as it lurches between extremes and settles on ever-higher taxes. Still, the Autumn Statement’s fiscal plans were not a surprise. The approach and policies were widely trailed. Resetting the government’s energy price guarantee 20% higher in Apr-23 was the most prominent news to us. Unfortunately, this unimaginative approach was not the only inflationary effect. Raising entitlements and the minimum wage by about 10% risks extending second-round effects (see UK: Fiscal Stealth and Strategic Weakness ).

More generally, I expressed my concerns (ok, I ranted a bit) about the government’s ongoing fiscal strategy, which further erodes work effort incentives. Continuing to push the tax burden beyond a post-WW2 high is a recipe for deepening the UK’s stagnation. And with that being the starting point for a likely Labour government reluctant to adopt current spending cut plans, UK taxpayers have a painful outlook for at least the coming decade. Nonetheless, plans for relatively deep fiscal restraint beat no plan. Markets typically tolerate rolling horizons for fixing things, although high issuance is a threat that could jar with an inefficient QT strategy. The BoE auction on Thanksgiving is the next of those hurdles to clear. That shouldn’t cause another hard fall to earth, but the “hurdlers” need to keep this up for years without getting tired, even as primary issuance rises.

There isn’t much data yet on how the economy withstood the Oct-22 market indigestion, although the housing side is worryingly poor (see UK: Housing Market Skids Toward a Crash , 10 November). Retail sales still rebounded with the normalisation of working days after the Queen’s funeral. It also appeared to draw support from Amazon’s “Prime Early Access” sale. An end to that should weigh on November, despite Black Friday. We expect a dip below the bleak retail trend from high inflation squeezing real incomes and sales. Rising rates also depress disposable income and will probably push retail’s trend pace below real incomes (see UK: Retail Rebounds to Still-Bleak Trends ).

At least most people still have jobs or are too rich in retirement to need one. However, in Sep-22, the UK unemployment rate surprisingly jumped to 3.6% as the single-month rate surged by 0.3pp. It is tracking a rise towards 3.8% in Q4, about 0.1pp above the BoE view. Demand in the official vacancies and redundancies data is falling further from their peak, toward the Adzuna version, but continues to imply a cushion to output falls. Overall, this surprise UR rise restores the cyclical ageing of the labour market while remaining outside the “burn-out” phase. We still see hawkish pressure fitting a 50bp BoE hike in Dec-22 (see UK: Labour Fits the Fall Season ).

That is despite high inflation in Oct-22, which was more news to the market than the BoE or us. Specifically, UK inflation surged beyond our above-consensus forecasts (we were 0.3pp and 0.5pp over the CPI and RPI consensus) to hit 11.1% on the CPI and 14.2% on the RPI in Oct-22. Food prices drove most of the upside for us. Underlying inflationary pressures remain far too high. Indeed, the monthly impulse in the median rate is near its highs, as are the annual rates of most other metrics. We still see this as the peak, but a repeat of recent upside news could easily extend that further in the next few months (see UK: Energised Inflation Is Not Controlled ).

Meanwhile, the final print of EA HICP inflation trimmed the flash again in Oct-22 to 10.6%. This revision was driven by Italy, as we previewed last week, but it remains far too high. Underlying inflationary impulses have increased in some countries and are generally stuck near their highs. This resilience in the euro area remains a significant concern. We fear a repeat of the average forecast drift pushing peak inflation higher, which would encourage the ECB to hike by 75bps again. So our view still has upside risks (see EA: Huge Final HICP Print Trimmed Again ).

President Lagarde has also reiterated the ECB’s need to do more and likely hike beyond just removing stimulus. That shift into an outright tight setting is appropriate if there is excess demand or a de-anchoring of inflation expectations to the upside. Once the inflation problem is resolved, rates would need to ease back to neutral, or inflation would fall below the target. The ECB faces the same optimal policy approach as the Fed and BoE. Over the past week, the market has trimmed a few basis points from the slope in 2024, but it is still weirdly upward-sloping, contrary to the ECB’s strategy and peers. We still see this as a fundamental mispricing to correct.

The Euro is currently attracting more attention as it threatens to break technical resistance levels. Although the euro (and GBP) looks too cheap on a long-term valuation basis, that doesn’t typically matter until something triggers a break towards it. A lot of risk premium has already been priced out of European assets, while the modal scenario and distribution of possibilities still look worse in Europe. Even the ECB’s Financial Stability Report highlighted that risks increased recently. Such developments may have moved enough for fuller analysis soon…

Ultimately, I’d gauge the market’s appetite against technical resistance before pushing the likelihood of any directional currency view. I realise that’s a luxury I have as an economist, where such things are merely conditioning assumptions. FX strategists must still do their thing, even if too many exist as glorified momentum signals – i.e. markets did X because of Y, so Y will move it more, which in the limit is tedious noise amplification. So excuse me if I don’t jump on their bandwagon.

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