28 October 2022: Sunak inspires confidence in City of London bankers

GBP – Investment background means he speaks their language

The UK has its first Prime Minister of South Asian descent and its first Hindu Prime Minister. But perhaps most critically for the economy, it has a Prime Minister with a background in investment banking.

His experience means he can speak to City of London bankers in a language they understand and hopefully promote confidence in his policies.

The contrast with the previous Prime Minister and Chancellor of the Exchequer could not be starker. The performance of Sterling this week was an obvious sign that Sunak had restored the City’s confidence.

Another think tank that has lost credibility during the mayhem of the past eight weeks or so is the Institute of Economic Affairs, which originally planted the seed of trickle-down economics in her mind.

When Sunak spoke of mistakes being made by the earlier administration, he stopped short of naming and shaming the institute, who he used to use as a sounding board.

Hunt and Sunak can look forward to November 17th with less trepidation than the public. The trick will be if Jeremy Hunt can announce tax increases and cuts in benefits without causing a major furore. The triple lock on the state pension which has been a major cause of consternation throughout the country is still undecided.

The decision whether the country can afford for pensions to rise by the cost of inflation has not been made. It is likely that Sunak will confirm that pensions will rise by 10% next April. Not doing so would invite criticism and give the Opposition the perfect excuse to continue attacking government policy.

The pound failed to see any follow-through from its rally over the first part of the week. It fell to a low of 1.1548 versus the dollar and closed at 1.1579. While it stays above 1.1500, it should garner further support.

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USD – GDP data may not tell the entire story

The US economy grew by 2.6% in the third quarter, having contracted for the first two quarters, putting it in a technical recession.

The data is a rear-view mirror snapshot of activity, and given the data released thus far, there is evidence that tighter monetary policy is effecting output.

There were several reasons for the rebound, which masked the true extent by which the economy is weakening. The trade deficit fell sharply, driven by weaker consumer activity and an increase in oil sales.

Consumer demand fell sharply, growing by just 1.4% over the period from July to September. This is a sign that the economy is faltering, in line with several forecasts.

The forward strength of the economy is a more reliable basis on which to predict a recession. Demand rose by 0.1% in the third quarter, which is lower than in each of the first two quarters.

This year, interest rates will have gone from almost zero to 4%, provided the Fed keeps to its policy of seventy-five basis points at each of the past three meetings.

The tightening of monetary policy is the most aggressive in history. With interest rates firmly in restrictive territory, the effect has been magnified. The market will be particularly interested in the employment data, due next week, to see if that area of the economy is showing further signs of cooling.

Weekly jobless claims appear to have reached a plateau, hovering around 200k new claims, while the four-week average has reached 219k

Data for durable goods order was also released yesterday. It showed that orders for big ticket items like ships and aeroplanes continue to defy general expectations.

As the turmoil created by events in the UK fades, risk appetite has driven the Dollar lower. Yesterday, it retraced some of its losses from the earlier sessions, but remains below resistance at 110.90. It reached 110.62 and closed at 110.5y.

EUR – Rates still have some way to go to reach neutral

The European Central Bank didn’t disappoint the market yesterday, doubling short-term rates to 1.50. Rates still have some distance to travel before they reach a neutral level, which is neither accommodative nor restrictive.

Until then, consumers will have to endure the ECB’s tentative actions, paying higher interest on mortgages, personal loans and credit cards.

There had been political pressure on the Central Bank to tread carefully, given the parlous state of the economy, but Christine Lagarde and the rest of the Governing Council stuck to their mandate of targeting an average inflation rate of 2%, and are likely to do the same next month.

In her press conference following the interest rate decision, Lagarde was sanguine about tighter monetary policy, intimating that the Central Bank had no other alternative despite the slowdown in activity in the economy.

News of the rate increase, with the promise of more to come, brought fears of a recession bubbling to the surface. Observers and economists believe that a recession is now unavoidable.

Lagarde will find it difficult to avoid criticism that her continued support for weaker economies drove inflation higher. The pace of interest rate increases has slowed the economy to such an extent that a recession is expected to start in Q1 of 2023 and continue for four or five quarters.

The European Commission will try to avoid any blame for the state of the economy as they leave all monetary policy decisions to the Central Bank while they do nothing about fiscal policy.

In the New Year, Brussels will likely face pressure to rein in those nations who continue to see budget deficits in excess of 3%, while Germany rails at the fact that they are in effect guaranteeing borrowings which drive debt to GDP ratios well above 100%.

The Euro is still proving a false impression to the market that it is comfortable around parity. Its recent rise will have had a positive effect on inflation, but its stability at current levels appears tenuous.

Yesterday, it rose to a high of 1.0093, but the ECB’s behaviour drained the market’s confidence, and it closed at 0.9965.