The pound remains in crisis, it had another surge lower to $1.0350 overnight, although it has recouped all losses at the time of writing, caused by expectations that the Bank of England will release a statement or hold an emergency rate hiking meeting soon. The “doom spiral” for the pound is only being remedied on Monday by the prospect of BOE action, however, according to Bloomberg, the BOE has yet to decide if it will make a statement on the pound’s collapse to its lowest ever level versus the USD, and instead is watching the market closely. While the FX market is putting its faith in the BOE, we are a little more sceptical. If they can’t decide if they should intervene in the markets, then it’s unlikely any action or statement will be that illuminating, with the prospect of further losses for GBP/USD and a fall to parity still a high probability event in the coming weeks.
A hamstrung BOE and the risk of more declines for the pound
The other risk for the BOE is that the only lever that they have to pull is to raise interest rates, higher interest rates = more pain for the UK economy. They can’t intervene in the FX market, or at least they shouldn’t do this, as the BOE only holds 3% of GDP in FX reserves. Thus, the UK can’t afford to defend its own currency. This compares to huge currency reserves elsewhere including Japan (20% of GDP) and Switzerland (15% of GDP). In fairness, this is to be expected, Japan and Switzerland historically intervene frequently in FX markets, however, it does leave the UK exposed when they experience a sterling crisis. Also, the BOE does not have a bond-buying programme that it could rely on to dampen down upside in UK bond yields, a la ECB. We doubt that the BOE will implement one, as this will loosen monetary conditions at the same time as the BOE is raising interest rates to being inflation under control. Thus, the BOE may not be able to deliver the big sterling support package that the market wants right now, which could be kryptonite for the pound and trigger a sell off down the line. No wonder the BOE is taking its time releasing a statement.
The risk of a political meltdown grows
Added to the woes for the pound right now, the markets’ reception to Friday’s budget also appears to be stoking a political crisis. A spokesman for Liz Truss’s government, said that the government doesn’t comment on financial markets, however, there are rumours that letters of no confidence are being submitted to the 1922 Committee. Surely, another no confidence vote against a Prime Minister can’t be met with another round of voting by Tory members, instead it will lead to a general election. We have said in previous notes, that one endgame for the pound’s collapse is a change in government, we wouldn’t be surprised if this happens, especially if steps taken by the BOE don’t work to stem the decline in pound in the short term, if that happens then a Christmas election could be on the cards.
From a market’s perspective, at the time of writing GBP/USD has recouped all losses since the late Sunday slump, it is currently trading below $1.09, and the markets’ attention has turned to the bond market. As one would expect, rising expectations of a super-size BOE rate hike to boost the pound, has led to large losses in the bond market. Since yields rise as bond prices fall, the 2-year Gilt yield has risen by another 54 basis points on Monday, while the 10-year yield is up 22 bps, and the 30-year yield is higher by 16bp. Thus, the 30bp difference between 2 and 10-year yields is a massive inversion of the yield curve, which typically symbolises that the market is betting on a severe recession. Considering the government’s budget was designed to boost growth, its calculation has seriously backfired. Some media outlets are quoting a source that says the government was warned that the markets were febrile right now and very reactionary to any change of the status quo, however, Kwasi Kwarteng chose not to listen. It could be a costly mistake if it causes Liz truss to lose her premiership.
What to watch
When it seems like Rome is burning, it can be easy to forget about economic data, but there are some important releases to remember this week, including: Eurozone inflation, UK mortgage and lending data and US consumer spending. The Eurozone preliminary inflation data for September is released on Friday. The market is expecting headline inflation to rise by 1.2% on the month, with core inflation rising by 1%. While the annual rates aren’t expected to rise by as much, we think it’s more important to concentrate on monthly data right now. Thus, this level of price increase is not acceptable to the ECB, in our view, and it will lead to other large rate hikes this year and into 2023. This could cause Eurozone bond yields to rise, so far, they have been ignored in the sell off, with the market focussing on UK gilts. However, a potential sell off could be coming, and the catalyst could be Friday’s inflation report, although the ECB’s bond buying programme could reduce the chance of sharp increases in bond yields. Elsewhere, the US Commerce Department’s Personal Consumption Expenditures Index is released this week, the market expects a 0.2% increase in US consumer spending for August, reversing July’s decline. The BOE will also release UK mortgage and credit data for August, however, conditions have tightened considerably since then, so this almost renders this data obsolete for now, with data from September onwards much more useful.
Overall, the focus is the FX market, will the BOE save the pound with a mega rate hike, and will there be unilateral action to stem dollar strength? It is worth noting that every major currency is lower vs. the USD today, not just the pound, the dollar is king.
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