Sterling and UK Debt Market Respond Favorably to the Return of Orthodoxy

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Marc Chandler
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Overview: The markets have returned from the weekend with a greater appetite for risk. Equities and bonds are rallying, and the dollar is better offered. China, Hong Kong, South Korea, and Indian bourses advanced. Mainland shares edged higher even though Zhengzhou, a city of one million people, near an iPhone manufacturing hub was locked down due to Covid. Europe’s Stoxx 600 is up nearly 0.5% to extend its recovery into a third session. US futures are trading a little more than 1% higher. European benchmark bond yields are 10-12 bp lower and the 10-year US Treasury yield is seven basis points lower to 3.95%. The reversal of the UK’s fiscal policy and a new Chancellor of the Exchequer has seen British Gilts rally strongly. The 30-year Gilt that traded briefly above 5.0% last week is off 34 bp today to 4.44%. A break of 4.25% would target 4.0%. Sterling is leading the major currencies higher today with around a 1% gain. The greenback is trading lower against all the major currencies, though it is virtually flat against the yen. Emerging market currencies are more mixed. Asian currencies are mostly softer, while the South African rand and Mexican peso join the central European currencies moving higher. Gold has stabilized after falling nearly 3% last week. It is approaching $1660, and the nearby cap is seen closer to $1670. December WTI is little changed. It fell 7.3% last week after rallying 16% the previous week on OPEC+ cuts. US natgas is off 3.4%. It gapped lower and is at its lowest level since mid-July. Natgas prices in Europe are tumbling as a cap is being discussed. Europe’s benchmark is at its lowest level since late June. It is down 4% today. It fell 9% last week, for its seventh consecutive weekly decline. Iron ore prices fell 2% today, giving back the pre-weekend gains in full. December copper is about 0.25% firmer, recouping half of what it lost ahead of the weekend. December wheat is starting the new week with a 1.4% advance after tumbling 3.6% at the end of last week.

Asia Pacific

Xi’s speech at the 20th Party Congress in China seemed to offer little but a new confirmation of the current trajectory. In some ways, leaving out the political structure (I know, it is a bit like asking Mrs. Lincoln, “despite that, how was the play?), Xi sounded like many leaders of other countries while underscoring that economic development was the top priority. He talked about “common prosperity” limiting income and wealth inequality, recognizing markets’ decisive role in allocating resources, and that housing is “for living not speculating.” Reports indicate that in his two-hour speech, Xi had a section on “human capital.” Xi’s views on welfare are not so different than many liberals and neo-liberals in the US and Europe, and on more than one occasion, he has warned that welfare supports “lazy people.”

Xi’s emphasis on self-reliance (the word counters say he said it twice after not citing it at all in his 2017’s speech) may be a recognition of the US tightening technology noose. Earlier this month, the Biden administration took the strongest steps to block China from developing start-of-the-art semiconductor capabilities, which have dual use–civilian and military. The full ramifications of the latest US controls are still rippling through the industry. Still, it appears that US citizens, including green card holders, cannot support the development or production of semiconductor chips at many (28) Chinese firms, which means employment and sales, shipping, servicing, and support. Taiwan’s intelligence estimates that around 200 US passport holders are employed in Chinese semiconductor companies. It will work through third countries too. Even though the US is not the center of chip fabrication that it once did, US software is critical in chip design. Some pundits claim this “coup-de-grace” is a significant blow to this key industry. As the share prices have shown, it will also hurt several US chip companies.

There is some speculation that the Bank of Japan may be intervening quietly and read into the BOJ’s daily balances, the possibility that it sold a little less than $7 bln dollars to defend the yen. The first intervention last month was a record near $20 bln. To go from trying to muscle the market to quietly offering support to the yen seems unlikely. Moreover, the whipsaw in the exchange rate that is the intervention hypothesis is supposed to explain took place after the stronger than expected US CPI figures on October 13 in the North American session. That said, the Ministry of Finance Kanda did warn last month that “stealth” intervention was possible and that official confirmation would not always be provided.

If the BOJ did intervene, which we doubt, did not have much impact. The dollar reached JPY148.85 ahead of the weekend more than a full yen higher than seen on October 13. It is in a little less than half-a-yen range today below JPY148.80. If we are right that intervention in Japan’s time zone, then the dollar is likely to make its highs in Europe or North America. The Australian dollar rose to a marginal new high for the week ahead of the weekend before reversing and settling on its low slightly below $0.6200. It is trading with a firmer bias today, though it stalled near $0.6250 in the European morning, where options for A$465 mln expire today. A bit higher, $0.6270 are another set of options for nearly as much (~A$425 mln) will also roll off. The greenback remains firm against the Chinese yuan and is trading above CNY7.20. The high from late September was a little above CNY7.25. As expected, the benchmark Medium-Term Lending Facility rate was unchanged at 2.75%. The PBOC has steadied the daily dollar fix to around CNY7.10 and continued today with a CNY7.1095 reference rates. The median in Bloomberg’s survey was for CNY7.1977. This appears to be the widest gap. Reports suggest that Chinese state banks swapped yuan for dollars in the forward market and sold dollars in in the onshore market to support the yuan.

Europe

The SNB has tapped the Fed’s dollar-swap line for the past two weeks. On October 5, nine counterparties took $3.1 bln; last week, 15 institutions got $6.27 bln for a week. There are two general views. The first sees it as troublesome and an expression of the global stress being stoked by the reduction of dollar liquidity and growing systemic risks. A large Swiss bank has been the subject of rumors and speculation for weeks, but the number of counterparties suggests something more/bigger. The second view the use of US swap lines to secure the dollar as part of an arbitrage-like opportunity. Taking the dollars from the SNB’s swap line, swapping them for Swiss francs, and depositing them with the SNB is a nearly risk-free pickup of an estimated 40-50 bp. Earlier, a similar type of arbitrage seemed to drive dollar-based investors’ demand for Japanese government bonds. Then, the currency swap was greater than the bond’s interest rate.

Separately, while much of the coverage of central bank intervention has focused on Asia, some suspect the SNB may have quietly sold dollars near CHF1.00. The idea is that the SNB has become particularly hawkish and wants to resist currency weakness. The dollar is the second most important currency for Switzerland. Total sight deposits fell 3% last week, which one would expect amid dollar-selling intervention. Still, as we have previously suggested, it is also consistent with the SNB’s efforts to mop up excess liquidity. Total sight deposits have fallen by nearly 20% over the past four weeks or CHF134.7 bln.

When the UK government scrapped the cut to the highest marginal tax, many said it was a U-turn. We thought it was a relatively small dilution of its fiscal thrust. The shift before the weekend to embrace the Johnson/Sunak corporate tax increase is more significant and cost Chancellor Kwarteng his job. Hunt, whose fellow MPs rejected his bid to be Prime Minister, is the new Chancellor. Reports suggest he is committed to delivering the fiscal statement on October 31. Hunt may drop the one-percentage point cut in income tax that was to be implemented next year. The focus shifts from taxes to spending. One issue is whether welfare payments will be raised to blunt inflation, as Johnson had promised. Hunt is expected to make a statement late in the UK morning on measures to support fiscal sustainability and then will address the House of Commons a few hours later.

Hungary surprised the market before the weekend. Last month, it signaled that it was done lifting rates and would focus on draining liquidity. The central bank introduced a new one-day deposit facility at 18%, compared with the base rate of 13%. It also indicated that it would use reserves to counter the rise in energy prices. That could cost around $1.5 bln a month. As a result, the forint recovered by about 4.2% against the euro ahead of the weekend. There has been no follow-through forint buying today and the euro recovered from about HUF416.35 to HUF419.25 before steadying in the European morning.

The euro held above the pre-weekend low slightly below $0.9710. Then it rallied nearly half a cent through the European morning. A consolidative tone is threatening. Last Thursday and Friday’s high were recorded a little above $0.9800 and this remains the nearby cap. Options for almost 1.6 bln euro struck at $0.9800 expire on Thursday. Sterling is up around a cent in the European morning around $1.1275. It did initially slip through the pre-weekend low to dip below $1.1150 but recovered quickly. The high from the end of last week was $1.1365-80 this needs to be overcome to lift the tone and signal a re-test on the $1.1500 area.

America

The robust September employment data was followed by a stronger-than-expected CPI and respectable retail sales (0.4% core and August revised to 0.2% from 0). Despite the lagged nature of the data points, if the Fed were to say to its critics that after raising the Funds target by 225 bp and doubling the pace of the balance sheet unwind over the past 100 days, we venture that interest medium-and long-term US rates would rise rather than fall. Core CPI is at a new cyclical high. Headline inflation is higher. Frankly, the Federal Reserve seems to be moving in the opposite direction. Encouraged by Bullard, the market will take more seriously the chances of a 75 bp hike in December after a 75 bp hike in early November. The October Empire State manufacturing survey is on tap today (unlikely to be a big market mover), and while no Fed officials are scheduled to speak, the revelation that Bostic may have violated the Fed’s trading rules is being discussed by market participants. Bostic and Kashkari speak tomorrow ahead of the Beige Book on Wednesday.

The combination of stepped-up hawkish rhetoric by Bank of Canada Governor Macklem, despite words of caution from the IMF about risks of recession from the collective hikes, and the prospects of a more aggressive Fed has lifted expectations for a 75 bp hike next week. After the Reserve Bank of Australia raised rates by a quarter-of-a-point, some observers thought it was a tell for a more moderate pace by Canada. Still, Macklem put that to bed, The market accepted that a 50 bp was most likely, but in recent days, expectations for a 75 bp move have increased. The swaps market now sees about an 78% chance of another three-quarters point move.

Firmer equities can help the Canadian dollar pare last week’s 1% decline. The Canadian dollar fell to new two-and-a-half-year lows in the middle of last week. Trading remained choppy in the second half of the week and the greenback finished slightly below CAD1.39. It has not been above CAD1.3880 today and there are options for nearly $900 mln at CAD1.3900-05 that expire today. We suspect that they may have been neutralized ahead of the weekend. A break of CAD1.3800 could spur a move toward CAD1.3740-50 today. The greenback is offered against the Mexican peso, and it is approaching the lower end of its recent trading range. It has not traded below MXN19.9350 this month, but a break could signal a move to the bottom of the wider range, which extends to around MXN19.80. It is a quiet week for Mexican data and the highlight is the August retail sales report on Friday. A small rise is expected.