Even though oil prices peaked in spring, much of the time since saw gas prices firming higher, because of the war in Ukraine, adding to problems for western Europe, including the UK. In recent weeks, though, gas prices, too, may now be heading lower. If this continues, then this would be a significant development.
Interest rate expectations, the strong dollar and the outlook for policy in the UK are three of the main current issues. In recent weeks interest rate expectations have shifted, with the market not only expecting US and UK policy rates, for example, to peak at higher levels next year, but just as importantly, markets are no longer expecting policy rates to then fall significantly as they had done before.
This shift in market expectations is in line with the macro view we had held previously. After a prolonged period of cheap money, not only are central banks under pressure to hike but once rates peak, they are likely to stay elevated.
For instance, UK policy rates are 1.75%. The market expects rates to peak close to 4.5% early next year, but then not to fall, but remain elevated. It is interesting to note, though, that over the last week the market has simultaneously focused on whether increased government borrowing may lead the Bank of England to scale back on its pace of quantitative tightening (QT) while also focusing on whether there will be a 0.75% hike at the next Monetary Policy Committee.
I will not repeat all our previous comments on the Bank, suffice to say that the direction of policy is for monetary policy to tighten but that the speed, scale and sequencing between hikes and reversing quantitative easing (QE) needs to be sensitive to the needs of the economy.
Elsewhere, the ECB has hiked 0.75% in recent days. While in the US, the clear message from the Federal Reserve (the Fed) – both from Powell’s clear, concise speech at Jackson Hole recently and from other comments from policy makers – is that monetary tightening will continue.
There needs to be lasting, consistent and meaningful evidence that inflation has peaked for the Fed to change its tone. It is clear we are not there yet in the Fed’s minds. Headline rates of US inflation may have peaked, but the Fed does not want to stop tightening prematurely, although the pace and scale of hikes may ease. They have already indicated their desired path for gradually shrinking the balance sheet.
As is the story here in the UK, despite monetary tightening, and talk of a slowdown, the US jobs market remains healthy. It used to the case that economists would view the jobs market as a lagging indicator of the economy’s performance. It is now more of a coincident indicator (and perhaps even more so in the UK than in the US). Also, an important measure of US services – the purchasing managers’ index (PMI) measure – showed its strongest growth in four months, rising from 56.7 in July to 56.9 in August.
Against this backdrop the dollar is very strong. It is not just sterling that is weak, although that is often the impression that given from the main UK news. The weakness of the yen is particularly interesting, as often the yen used to be seen as a safe-haven currency in previous times of uncertainty. However, its weakness now is not a surprise, as while the Fed has been tightening the Bank of Japan has been focused on keeping policy rates and bond yields low. Sterling is now back to its 1985 level against the dollar.
The last time the dollar was this strong, globally, led to concerted international action by the G7. That was at the Plaza Accord of August 1985. It worked, so much so that this led to the Louvre Accord in spring 1987 to halt the dollar’s correction evidenced over the intervening 18 months.
Now, given inflation worries, the US may not appear keen to halt the dollar’s rise. Yet, the combination of higher US policy rates and a stronger dollar is often seen as a difficult backdrop for emerging markets – even more so if the Chinese economy is not growing strongly. Thus, a strong dollar is a current concern for financial markets.
It is against this backdrop that one must also judge events in the UK, where Liz Truss is the new Prime Minister and a shift in economic thinking and policy is inevitable. In my view, this shift will be positive for the economy as a pro-growth strategy becomes centre-stage.
When he was Governor of the Bank of England, Mark Carney described the UK as depending upon the kindness of strangers. That is because the UK has a large current account deficit and thus needs to attract capital inflows. This is not normally an issue. Indeed, the UK has often been seen as an attractive investment destination – just look at the foreign money that pours into UK property as one of many examples.
But if there is a change in sentiment there can be trouble – especially if the overseas money in UK assets like gilts and equites decides to leave and speculators short the pound. That is the fear now. Yet if they analyse the new policies on offer financial markets should be reassured, not frightened.
The combination of a weaker pound and rising yields of recent weeks is not a good sign. But as noted, this is largely because of a strong dollar. Of course, the pound weakened against the euro, too, in recent weeks, although the markets had been anticipating the large rate that the ECB has just announced, and a few weeks earlier it had been the euro itself that was under downward pressure. Also, higher yields were not specific to the UK over the last month. Yields have risen across western markets.
What, then, will the market focus on in terms of the new PM’s policy?
First, the announcement of a new policy to address the distortion in energy markets should be welcome, as it was needed and it is credible. The Johnson Government had already provided £37 billion of assistance this year to address the cost-of-living crisis. But as the war persisted the energy crisis worsened and thus fixing energy prices makes sense. Markets are likely to see this as positive for the economy.
Second, removing the confusion that has surfaced about the Bank of England is important. While the Bank has little credibility and is suffering from a communication problem, the Chancellor is clearly trying to help correct this, announcing this week that he will have regular meetings with the Governor. Kwasi Kwarteng has said monetary and fiscal policy need to work together. He is right.
However, the market misinterpreted previous comments from Truss during the leadership campaign, believing that politicians were now going to set interest rates – and also that this might mean that rates would remain low. Yet Truss has been clear throughout: the Bank will retain operational independence over monetary policy and would thus continue to set policy interest rates.
Third, the new Government will explain the narrative to the financial markets so that they understand the new policy stance. Monetary policy needs to curb inflation, fiscal policy stabilise the economy.
Without fiscal easing – that is, sticking with current tax increases – and without fixing the energy crisis, there would likely have been a deep recession. With the action to fix energy prices and with fiscal easing (as endorsed by Truss) the recession may even be avoided.
Such fiscal easing is necessary, affordable and non-inflationary. Markets need to be convinced of the latter.
The nature of our inflation shock is supply-side factors and poor monetary policy, not an overheating economy. Domestic demand is softening. Therefore, fiscal policy is not inflationary and should be eased.
Also, it is affordable. The maturity of our debt is very long term and alongside the still low rates at which the UK can borrow, means that borrowing should be seen not as a constraint but as a policy option. But it is clear that the new Government will be focused on fiscal discipline, and will reduce the ratio of debt to GDP over time.
Thus, the UK policy backdrop is a positive one: addressing the energy crisis and easing fiscal policy to prevent recession and help the economy; with clarity that the Bank retains independence over monetary policy, as was always going to be the case; plus a focus on a tighter monetary policy to curb inflation and a credible fiscal stance to both stabilise the economy now and get the public finances back into shape.
Please note, the value of your investments can go down as well as up.
