The challenging global macro backdrop is testing policy makers to the extremes. Some like the BOJ prefer to ignore external realities and maintain accommodative monetary policy while the UK is erring on the side of reckless fiscal policy expansion. Both are highs stakes gambles that in times of inflation will most likely not end in a soft landing.
It has been an extraordinarily volatile 5 day period in global markets, with some of the largest moves in rates and FX markets outside of peak crisis periods (GFC, EZ debt crisis, Covid). This volatility reflects (a) a shift in the markets understanding of how long and how restrictive policy will need to be to control inflation and (b) an understanding that politics may exacerbate the risks presented by this environment.
There were three main developments that worked together in concert last week.
1. Monetary policy actions
This week, there was a clear theme from the Fed, SNB and BOE. Each central bank under delivered relative to expectations for this meeting, but signaled a higher for longer approach to the rate hiking cycle. This shift away from front loading means the peak of the rate hiking cycle is further away, and increases the probability of rates remaining restrictive for longer. The net result is an increase in term premium globally. This is risk negative and also signals that the hiking cycle is earlier in its life cycle than previously thought.
2. Geopolitical developments
President Putin announced a partial mobilization of reservists and conscripts to fight the war in Ukraine under the guise of secession referendums in Russian held provinces in Ukraine. He also signaled a willingness to use tactical nuclear weapons. This meaningful escalation increases the risk of a prolonged war in Ukraine, as well as a significant military escalation on the part of Russia. This in turn increases the risk of further reductions of energy exports, sanctions, and a humanitarian crisis in Europe should the war re-escalate beyond the front lines. The net result is a heightened probability of additional stagflationary impulse for Europe via lower growth (confidence) and rising energy costs alongside higher tail risks.
3. Major UK Policy Shift
The new Conservative government announced a historic policy shift today in the UK. Previously the party of fiscal prudence, the new chancellor announced the largest tax cuts (focused on income tax and housing) since 1972, alongside the fiscal package to cap energy prices. This is, in effect, a massive unfunded stimulus package at a time when inflation in the UK is >10% and the 1Q current account deficit was -8%. The likely impact is to push the UK fiscal deficit to 6-8%. Twin deficits to this degree are among the worst of any developed or developing economies in the last 20 years.
This was a major surprise. The government had kept the tax cuts secret to achieve maximum political benefit, with the result that the BOE's policy decision looked wildly out of sync yesterday. The effect is that UK fiscal policy is now maximally stimulative, while the country faces an inflation shock, with the government fiscalizing the energy inflation shock while reducing its domestic tax base.
The moves since the mini budget in UK fixed income have been extraordinary; UK 2y swaps have risen by 95bps in two trading sessions, and the GBP has had a 10% range on Monday alone.
This type of volatility is consistent with a crisis, and is reasonable given the macro vulnerabilities of the UK. The BOE will likely need to raise rates much more than they expected, bringing UK policy into restrictive territory. With that, the risk of a destructive recession has increased further. However, the political response to a recession “created” by the Bank of England is highly uncertain. Risk premia in UK assets will likely remain elevated for some time to come.
The overall result of last week's policy moves has been a volatile increase in global term premium, alongside heightened stagflationary risks in Europe. Market volatility is indicative of a regime shift, and that is appropriate. Higher for longer means global liquidity conditions will remain restrictive until after the effects on inflation are tangible. This is de facto, the exact opposite of the inflation targeting policy that the Fed brought in in 2020.
This shift is significantly risk negative, negative for equities and negative for currencies with negative real yields, and / or dovish policy. It means the YCC policy in Japan is inappropriate for the environment. Reports suggest the MoF in Japan sold $20bn to intervene last week, and USDJPY is within 1% of the level they intervened at. In simplistic terms, if 1y risk free USD rates are 4.5%, why allocate anywhere else until the prevailing risk environment improves?
For countries facing a stagflationary shock, the outlook is worse. The UK has shown that there is a limit to how much the market will tolerate pro growth policies at a time of high inflation. For the ECB, failure to deliver the 180 bps of hikes in the next 3 meetings will place additional downside pressure on the Euro, but over delivery will likely push Italian bond yields above 5%. There are countries who can fiscalize this growth shock, but that is not every country in the Eurozone, and the great weakness of the Euro (no fiscal transfers) is again raising its head.
While effective policy responses from the BoE and the ECB may reduce near-term spikes in risk premia, the structural issues facing the global economy, and in particular Europe are not easily fixable. The market is becoming aware of these issues, but as the UK showed this week, there is much more room to run if confidence in policy makers is tested.