Thematic Macro Profits Taken

• Over the past week, the UK got a new Prime Minister, reassuring markets into a bullish UK start to an apparent unwind of global thematic positions. Activity and inflation data have been broadly bleak, pushing the ECB to hike into recession relentlessly.
• Next week, the policy baton passes to the BoE (and Fed). We still expect a 75bps rate hike, although that would no longer be a dovish surprise for others after markets and economists capitulated. We also expect Flash EA inflation for Oct-22 to hit 10.6%.

The week began with more political manoeuvrers in the UK. However, this time, they involved things going relatively smoothly and swiftly towards the market’s preferred outcome with Boris Johnson’s withdrawal from the Conservative leadership race. That also relieved many Party members, especially in parliament. Rishi Sunak’s appointment as Prime Minister means the parliamentary party has got its preferred option from the last contest without risking another vote from the broader party base. However, Mr Sunak’s challenges ahead are still more significant (see?UK Politics: The Sunak Also Rises?).

Squaring the fiscal circle will be one of the most significant challenges for Mr Sunak. He was a popular Chancellor when giving money away, but it is nearly time for unpopular tightening. That time has been postponed from Halloween to 17 November, though. The new PM probably wants to put his stamp on whatever Jeremy Hunt has been working on since getting in the hot seat in the fiery final days of Liz Truss. That delay may also allow the OBR’s official projections to incorporate recent yield reductions, which will spare some discretionary fiscal tightening. Allowing the drag from high inflation to do the hard yards still seems the most likely approach.

Markets have naturally responded favourably, with yields down and GBP up, especially against the USD. Yet these moves were not just about the UK, or even primarily caused by it later this week. We were concerned about the potential for investors to?Reduce Risk After UK Recovery?, as the residual under-pricing was small relative to volatility. Investors appear to have pared their positions far more broadly as popular macro trades unwound. So, the USD weakened, yields fell, and equities rallied on sequential days, potentially signalling short covering. Overall spreads tightened in the UK’s favour, but that move was concentrated on Monday. Pricing for the BoE outlook has fallen with the Fed rather than continuing to crash relatively. The cause matters for the resilience of the UK’s yield decline. Those global factors could quickly turn, so we remain concerned about how smoothly the market will take down the BoE’s active gilt sales beginning on 1 November.

The ECB also played a significant role this week, despite only hiking as expected by another 75bps, taking the total change to 200bp. Guidance of more hikes was extended beyond neutral, consistent with our forecast, but perhaps not the market. More controversially, terms for the TLTRO-III were rewritten to remove the arbitrage potential between it and the rising deposit rate. Extra repayment windows reduce the punitive effect but still harm the credibility of using similar measures after the ECB demonstrated the time inconsistency problem for policy. We maintain our forecast for the ECB to slow its hiking pace in December to 50bps, then 25bps in February and March 2023 to a 2.5% peak in the deposit rate (ECB: Aiming Further and Rewriting Rules?).

Risks to the policy rate outlook necessarily weigh the potential for tightening to trigger a crisis against the potential for inflation to push policy tightening into staying aggressive. The latter dominates in the short term, but they are not entirely independent risks. To the extent that high inflation motivates the ECB to do more, the risk of triggering a crisis rises. The flatness of the euro front end does not appear to reflect these associated risks, which would justify some inversion.

The Oct-22 flash inflation prints didn’t go one way, but the excruciating pain in some countries overwhelmed the news. HICP inflation was high in Germany at 11.6% (HTRO 11%, Con 10.9%), France at 7.1% (HTRO 6.7%, Con 6.4%), and Italy at 12.8% (HTRO 9.8%, Con 9.9%). Spain provided some disinflationary offset, undershooting our below consensus forecast to hit 7.3% (HTRO: 7.8%, Con 8.1%). Overall, we have raised our forecast for EA inflation by a whopping 0.7pp to 10.6%. That is above the early consensus by an even greater magnitude than our revision, consistent with us being less wrong than others on the member states so far, but there is likely to be some correction. The cumulative drift in the forecast remains both substantial and of significant concern.

Even with the tightening announced so far, pressures on the global economy are becoming increasingly evident. Manufacturing PMIs returned to their downtrend in October, with the US, EA and UK all appearing to face falls. All their services sectors are also now declining. However, unemployment has yet to rise. Until that occurs, any easing of wage pressures will only come from demand where there is a backlog of vacancies. Monetary policymakers are reconciled to the fact that a recession may be needed to curb inflation. Rate hikes should slow when success is evident (see?Global Recession Beginning?).

Preview: EA inflation in Oct-22 (Flash)

EA inflation has regularly exceeded consensus expectations in its flash releases, and the data out of member states so far has been faithful to that form. Germany and France both exceeded our already significantly above-consensus forecasts. Italy’s surge dwarfed expectations, while Spain provided a little offset by undershooting our well-below consensus forecast. Upside looks relatively broad-based, with the usual skew towards volatile food and especially energy components. Overall, we are tracking EA HICP inflation to hit 10.6% y-o-y while the core rises to 5.1%. That would be a concerning repeat of the consensus forecast drift (see?EA: Inflation Burns Up Forecasts Again?).

Figure 1: EA HICP inflation aggregates

Source: Heteronomics.

BoE Preview

UK markets and politics have been on a rollercoaster since the BoE’s forceful September decision to hike by 50bps. Thankfully, it limited its actions to supporting financial stability rather than smashing monetary policy around, or else it would have needlessly stoked economic volatility. Yet there has been no shortage of persistent news either, which the MPC needs to digest in its Monetary Policy Report.

Inflation has been surprisingly strong, while the unemployment rate has fallen further. More excess demand and inflation both point towards a need for tighter monetary policy than was previously expected. There is naturally a question of appropriate scale. Dysfunctional market moves were triggered by fiscal stimulus and post-rationalised as being all about that by many other commentators. Those fiscal changes have almost all been reversed, so it shouldn’t have much impact on the forecast update.

We track the mechanical impact of inflation and market news on the BoE’s 2yr forecast horizon based on its historic revisions (the evolution is plotted in the Monetary Policy Tracker below, in the PDF). That is a significant downward revision, indicative of the market overreacting. Except that is already essentially acknowledged by the market re-pricing down to a 75bp move, in line with our forecast. The impact of that is poorly captured by the BoE’s conventional 15 working day assumption for market prices as it happened during that period.

A critical underlying assumption for the 2yr horizon will be what the Bank assumes for household energy prices. The government’s energy price guarantee would have supported inflation at that point, partly through the demand stimulus it provides. That guarantee is now set to become conditional after six months, which may permit a spike in Apr-23 that cancels the medium-term inflation. However, the specific approach is not announced and may not affect inflation in April (e.g. if the discounted units are capped per household). The BoE will probably stick with official policy as usual and keep some offsetting stimulus to medium-term inflation from the energy price guarantee pending details. That would ensure the cut to the 2yr forecast is far less dramatic.

Overall, we expect the BoE to recognise the pressure from excess inflation and demand as justifications for hiking by more than it previously thought necessary. A record 75bp jump would fit that need. It would also mean the BoE is keeping up with its peers and market pricing, thereby limiting the likelihood of any undesirable renewed depreciation that unhelpfully imports more inflation to the UK. A smaller hike will probably still have some support, at least from Swati Dhingra, who also opposed the 50bp step in September. We doubt there will be enough support to limit the hike to 50bps as the MPC won’t want to rock the boat. Under-delivering can come later and potentially without issue as the markets re-price ahead of the event, as has happened in recent weeks. Indeed, the Bank’s forecasts will probably keep implying that the market is overdoing it.

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