CENTRAL Banks, led by the Fed, have spent the last few months pushing hard their hawkish credentials.
We have been told that combating inflation is priority one and if it means a recession then so be it. Markets have reacted by selling off risk but also moving rate expectations a lot higher.
However, the new UK Prime Minister Liz Truss and her Treasurer Kwasi Kwarteng have taken a more unconventional approach.
They seem to be focused on avoiding recession and hoping that somehow inflation will sort itself out.
Inflation is at its heart a demand versus supply problem. Central banks can’t control supply so they try to impact demand through rates. Fiscal policy can impact supply but it needs to be very targeted.
As a large energy importer the UK has little control over energy supply, at least short to medium term.
The fiscal support package announced on the weekend is partly an attempt to help address supply problems, but markets have taken it as merely propping up demand that is already too high.
GBP 72 billion of tax cuts were made across national insurance, corporate taxes, stamp duty and income taxes. Much of it will find its way to the wealthy, with more of a propensity to save than spend.
All this is on top of energy price caps that at current rates are worth GBP 160 billion over the next three years. They at least will keep headline inflation in single digits.
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The Bank of England is now faced with an even harder job to rein in inflation.
Markets have taken it that way, now pricing terminal rates above 5%. This was nearer 4% last week.
However, it is the extra supply that the bond market and currency market are struggling to assess.
At an extreme the price of 30yr UK Debt fell 10% after the mini budget. So far in 2022 UK 30 year debt has halved in price.
This all impacted on global bond markets in another tough week.
UK investors will potentially move money back onshore as their currency and rates become relatively more attractive.
Terminal rates in Australia are now back to pushing near 4.5%. Whilst domestically this looks very restrictive, global investors are not hanging around to find out.
Time will tell whether this huge gamble by Liz Truss pays off.
If global energy prices plummet, then they may get away with it. As it stands now though, markets are taking the view that the UK is falling deeper into a hole.
Tim Hext is a Pendal portfolio manager and head of government bond strategies in our Income and Fixed Interest team.
Tim has extensive experience in banking, financial markets and funding including senior positions with NSW Treasury Corporation (TCorp), Westpac Treasury, Commonwealth Bank of Australia, Deutsche Bank, Bain & Co and Swiss Bank Corporation.
Pendal’s Income and Fixed Interest boutique is one of the most experienced and well-regarded fixed income teams in Australia.
The team won Lonsec’s Active Fixed Income Fund of the Year award in 2021 and Zenith’s Australian Fixed Interest award in 2020.
Pendal is an independent, global investment management business focused on delivering superior investment returns for our clients through active management.
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