Bank of England Steps in to Buy Inflation-Linked Bonds for the First Time

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Marc Chandler
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Overview:  The dollar continues to ride high. It reached its highest level against the yen since the recent intervention. The Canadian dollar has fallen to its lowest level in two-and-a-half years and the New Zealand dollar is approaching the 2020 extreme. The greenback is firmer against all the major currencies but the Swiss franc, and against nearly all the emerging market currencies today. Equities have been sold. Japan, South Korea, and Taiwan re-opened after yesterday’s holiday and reacted dramatically to Washington’s latest sanctions on China in the chip space. Only Chinese shares, among the large Asian markets posted gains. Europe’s Stoxx 600 is off about 1.2%, its fifth consecutive losing session. US futures are off about 1%. US and European bond yields are firmer today. The US benchmark is approaching 4%, while in Europe peripheral spreads are widening. New efforts by the Bank of England have helped steady the Gilt market. Gold is extending its pullback for the fifth consecutive session. After trading near $1730 last week, it is below $1665 now. December WTI peaked yesterday around $92.35 and has fallen to $87.30 today. US natgas is off about 1% today after falling 8% in the past two sessions. Europe’s natgas benchmark is little changed after rising 2.7% yesterday. Iron ore fell nearly 2.5% today, giving back the lion’s share of yesterday’s 3% advance. The same is true for December copper. It is off 1.1% after advancing 1.3% on Monday. December wheat rallied 6.5% yesterday amid concerns about Ukrainian supplies. Those gains are being pared by about 1.25% today.

Asia Pacific

Japan's August current account underscores a weight on many currencies that continues to be attributed to monetary policy divergence. The deterioration of the external account in many Asian countries and Europe would likely spur an adjustment in the foreign exchange market. Japan's current account surplus averaged JPY471 bln (~$3.2 bln) this year. It averaged JPY1.59 trillion (~$12.2 bln in Jan-Aug 2021). The trade balance is overwhelming the income earned from past investments (yields, dividend, profits, royalties licensing fees, etc.). Japan's trade deficit on the balance-of-payments basis fell to JPY2.49 trillion in August from JPY1.21 trillion in July. The shortfall has averaged JPY1.173 trillion this year after a JPY313 bln in the first eight months of last year.

Another source of pressure on several Asian currencies is also coming from equity outflows. These equity outflows, especially recently, are not simply a function of tighter US monetary policy and would not necessarily stop or reverse if the Fed were not as aggressive. For example, even before last week's new US efforts to block China's access to advanced semiconductor chips and the technology to make them, the semiconductor industry was under pressure on this side of Covid. The US actions have aggravated the situation. Japan, South Korea, and Taiwan markets re-open after yesterday's holidays and the tech sector in general but especially the chip sector was hit hard. The largest semiconductor company in the world, TSMC, was off a record of more than 8% today, for example.

The dollar edged close to the JPY145.90 peak last month. The market hesitates, wary of another bout of intervention. It is likely misguided to assume that the BOJ will defend a particular level. Still, the market treads gingerly. Prime Minister Kishida endorsed the easy monetary policy stance, while the US 10-year yield is approaching 4%. Initial support is seen near JPY145.50. Last Thursday, the Australian dollar posted a bearish outside down day and it has fallen for the past three sessions. Today, it slipped marginally through $0.6250. Last Thursday's rejected high was around $0.6540. The next notable chart area is in the $0.6100-20 area. The 2020 low is still a distance off around $0.5500. Note, though the New Zealand dollar traded down to almost $0.5535, drawing closer to the 2020 low near $0.5470. After rising 0.5% against the Chinese yuan yesterday, the dollar is up almost 0.3% today. The PBOC set the dollar's reference rate at CNY7.1075 today. The median projection in Bloomberg's survey was CNY7.1375. A 2% band from the reference rate allows the greenback to trade today to almost CNY7.25. So far, it has held below CNY7.1950.

Europe

Reports suggest an important shift in Germany's position and now it can support a new joint EU debt issue. Germany had come under strong criticism for earmarking 200 bln euros to cushion the energy shock at home while objecting a joint EU bond to help others that do not have Germany's fiscal space. It is not clear yet whether objections, like from the Netherlands, will also be dropped. Germany insists, though, that if there are new funds they are distributed as loans not grants. This suggests the model/precedent is not the Next Generation recovery fund but SURE, which arose from the labor market shock of Covid. Its disbursement was completely on a loan basis. Some reports suggest German Chancellor Scholz wants to first have a better sense of Italy's new government's commitment to Europe. Still as news of the change in the German position spread, Italy's premium over Germany narrowed dramatically. The 10-year premium narrowed by nearly 25 bp, and around 227 bp, is the smallest in a couple of weeks. Italy' s premium on two-year money fell back below 100 bp, also a two-week low. It settled at 125 bp at the end of last week. The spreads have widened today, recouping some of yesterday's move. 

UK Chancellor Kwarteng was to speak to the Tory Party's 1922 Committee (formally the Conservative Private Members' Committee) tomorrow, but Prime Minister Truss will address the MPs herself. Recall that among the Tory MPs Truss lost to Sunak. It was the rank-and-file that gave her a victory. She campaigned, in part, on unwinding Sunak's tax hikes. Polls have shown the Tories have lagged Labour beginning in spring 2020. Rather than reverse the slide, Truss has widened it. Still, an election is not necessary until January 2025. The mini-budget may have been the proximate cause, but the Tories have led the UK government for 12 years. Voters are exhausted and the Tories broad agenda has fallen out of favor. The FT recently cited the latest British Social Attitudes survey that showed a majority favor increasing taxes and increased spending on public services (e.g., education, healthcare, and welfare). Just 1 in 17 thought taxes and spending should be cut. Among the Tories themselves, the survey found nearly half (46%) thought taxes and spending should increase.

After the inflation-linked securities in the UK sold-off hard yesterday, the Bank of England indicated that it would buy these securities in a bond-buying operation that is projected to terminate at the end of the week. It did not buy inflation-linked securities during QE. Of the new GBP10 bln buying wherewithal a day, it said as much as half could be used to buy inflation-linked bonds. Separately, the UK labor market report was somewhat stronger than expected, with payrolls rising 69k after a revised 31k increase in August (initially estimated at 71k). Notably, base pay rose 5.4% in August (from 5.2% in July) on a three-month year-over-year basis and is the seventh increase in the past eight months and is the fastest pace since August 2021.

The dollar traded above parity against the Swiss franc for the first time in nearly four months. It looks set to challenge the year's high set in May near CHF1.0065. This is a function of the demand for dollars, and it is obscuring a dramatic drop in sight deposits. They have fallen from a record high in mid-September to their lowest level since mid-2020, a 14.5% drop. Last month the Swiss National Bank declared it would use bonds and repos to steer market rates, and the decline in the sight deposits reflects just that. In late September, the euro fell to its lowest level against the Swiss franc since January 2015 when SNB abandoned the Swiss franc cap. It recovered from almost CHF0.9400 to almost CHF0.9810 last week. It pulled back to the minimum retracement (38.2%) near CHF0.9655. The SNB's stealth tightening, the anxiety ahead of the sitting of the new Italian government (the lower chamber will sit for the first time since the election later this week), and ideas that Russia may escalate its efforts after the weekend attack on the bridge that links Crimea to Russia may weigh on the cross. Technically, the momentum indicators look poised to turn down for the euro. 

The euro is in a narrow quarter-cent band around $0.9700. The four-day drop was initially extended into the fifth session, but it recovered in late Asia and early European activity. However, the intraday momentum indicator is getting stretched, suggesting North American operators may sell it again. The next important chart point is closer to $0.9645. On the upside, it probably requires a move above $0.9750-60 to draw attention. Sterling has traded below $1.10 for the first time this month. It remains heavy. The next downside target is around $1.0920, but in front of it today are GBP1.33 bln in options struck at $1.0925 that expire today.

America

Ahead of the PPI (tomorrow) and the CPI (Thursday), the US reports its monthly budget balance today. It tends not to be a market-mover, but it is a good reminder that it is not just about monetary policy. Fiscal policy is tightening aggressively. Consider in the first five months of the fiscal year, the US budget deficit has fallen from about $1 trillion last year to a little less than $277 bln this year. The median forecast in Bloomberg's survey projects the deficit to fall to about 4.2% of GDP this year from 10.8% last year. It took the better part of four years after the Global Financial Crisis for the deficit to fall from 10.1% of GDP (2009) to below 4% (2013). As interest rates rise, there is more attention of the cost of servicing the debt burden. The weighted-average maturity in the US is a little more than five years. By comparison, the UK's average is closer to 14 years. However, there is another rub to consider. Less than 9% of the US debt is linked to inflation. The UK's share is around a quarter.

Brazil is expected to report the third consecutive decline in IPCA inflation. It peaked in April slightly below 12.15%. It stood at 8.73% in August and the median forecast (Bloomberg's survey) sees it falling to nearly 7.1% in September. Lower fuel prices and tax cuts are expected to have weighed on inflation measures. The Selic rate is at 13.75%, which is seen as the potential peak. Chile's central bank meets tomorrow. It began hiking last July, two months before the Fed's pivot. After hiking the target rate by 100 bp last month, the market expects a half-point move that would bring its target to 11.25%. Inflation eased to 13.7% in September from 14.1% in August. It was the first decline since February 2021. The swaps market sees the terminal rate closer to 11.50% for Chile.

The Canadian dollar has been sold to new two-and-a-half year lows today. The US dollar has risen to CAD1.3855. The high for the day does not appear in place. It could rise toward CAD1.3880 today, but in the larger picture, we see a risk to CAD1.40. Given the Bank of Canada Governor Macklem's recent comments, the Canadian dollar's weakness may prompt the central bank to hike 75 bp at its next meeting on October 26. The market has only about a 25%-30% chance discounted now. We see it as closer to a 50/50 proposition and rising. The greenback is a little firmer today but remains below the middle of the MXN19.80-MXN20.20 band that has confined most of the price action over the past two months. Today, there is upside potential back into the MXN20.05-MXN20.10 area. While Brazil and Chile's tightening efforts may be over or nearly so, the swaps market sees another 125-150 bp of tightening from Banxico.