“After You”… “No, After You”

By Michael Every of Rabobank

Your Turn!

The summary of this week’s events feel like one of those cheesy “after you”, “no, after you” comedy scenes.

Basically, we’ve had the Bank of England tell the government “you turn!” after the mini-budget caused market turbulence, which was only met with the UK government telling the Bank “no, you turn!” instead. Behind closed doors the Bank of England then suggested to market participants “don’t worry, we’ll turn if we have to”, while Governor Bailey publicly maintained “we won’t turn”. Then, Chancellor Kwarteng essentially told the central bank “no, I insist, you turn!”, when he told Sky News that the Bank would be responsible for any renewed volatility after its temporary bond buying program ends. That’s the Chancellor throwing the Governor under the bus.

Meanwhile, Tories are screaming “Turn!!!” at the Prime Minister, with rumors of plans to replace Liz Truss, as well as rumours that 10 Downing Street may finally be backpedalling on parts of its fiscal plans. But regardless of how many changes the government makes, the government’s true uphill battle is reasserting to markets that they will be responsible with the UK’s budget. King Charles greeting Truss with “Dear, oh dear” underscores just how much of a mess the government has created.

Long-dated gilts dropped significantly yesterday, with the 10y yield declining ~25bp and the 30y gilt ending the day some 27bp lower. Yet, that could also be the result of another round of Bank interventions – while they still last. Because as much as any U-turn has been suggested, little actual turning has been done. So far, the only thing that has turned around is Chancellor Kwarteng’s airplane, as he left the IMF meeting in Washington a day early to return to London.

Over on that other side of the Atlantic, the US CPI data released yesterday removed any remaining doubts over whether the Fed might do a slight turn from their current trajectory: headline CPI inflation came in at 8.2%, which is slightly lower than last month’s (8.3%). However, the core reading accelerated by more than expected, to 6.6%. If anyone was still questioning if the FOMC might do another 75bp hike in November, this latest data point should give a clear signal that now is not the time to turn back to 50bp steps. Indeed, the market-implied expectations currently fully price a 75bp increase.

And that the ECB isn’t looking to do a quick U-turn on its policy either was already clear from the accounts of the September meeting. Recall that the ECB acknowledged that monetary policy was ill-equipped to deal with supply shocks, but that it clearly can affect the balance of supply and demand. To that avail, it was argued that “putting too much emphasis on supply-side problems could risk neglecting the fact that aggregate demand had to adjust to curb inflation.” In other words, the ECB will not be deterred by a moderate slowdown; in fact, it may actively need to cause one in order to bring down aggregate demand.

Unsurprisingly, outright support for another 75bp move this month has been growing since the previous meeting. More notably, though, Council member Simkus was the first to suggest that the ECB may have to opt for a hattrick, noting that a “75bp or 50bp hike is needed in December”. How many big hikes does it take before “frontloading” suffers the same fate as “transitory”?

Not only does that again put into question the ‘meeting-by-meeting’ approach that the ECB has adopted (and one would hope that policymakers have a bit of a longer-term view and strategy anyway), it also suggests that the ECB, too, will err on the cautious –in this case, read: hawkish– side as long as the inflation outlook does not show material improvement. Belgian central bank governor Wunsch told CNBC that he would not be surprised if the ECB has to hike above 3% at some point.

That said, the one policy area where there may have been some U-turning in the hawkish camp is quantitative tightening. Reducing liquidity is still very much on the Council’s agenda, and could start in the first half of 2023. But instead of active bond sales, the latest leaks suggest that a passive reduction of the balance sheet (i.e., not reinvesting the proceeds of maturing bond holdings) may be the preferred option. Before the Truss government made the Bank of England’s job impossible, some ECB policymakers were pointing at the plans of their UK peer to actively sell assets as an example. The ECB may have been taking notes as that plan unravelled rapidly. Although the backdrop for the ECB may be different than the UK’s situation, the central bank will have to remain mindful of the impact on spreads in order to avoid pushing any country into the ECB’s newly-created Transmission Protection Instrument, which would effectively see the ECB buy assets as it is reducing the balance sheet. These TPI purchases would be sterilized, but it would still render quantitative tightening partially self-defeating in terms of shrinking the ECB’s balance sheet.