Sterling Crisis Deepens as Kwarteng Doubles Down

September 26, 2022
  • Risk sentiment remains under severe pressure as the new week begins; markets are still digesting last week’s hawkish FOMC decision; many Fed officials will spread the hawkish message this week; August Chicago Fed National Activity Index will be reported
  • U.K. assets remain under pressure as Chancellor Kwarteng poured more gasoline on the fire; BOE tightening expectations have picked up as a result of the worsening situation; Italy is likely to become more of a market focus in the coming weeks; Germany reported a weak September IFO business climate survey
  • BOJ Governor Kuroda said he supported last week’s FX intervention; Japan reported firm preliminary September PMI readings; China continues to take small measures to support the yuan

The dollar remains firm as the new week begins. DXY is up for the fifth straight day and traded at a new cycle high near 114.527 during sterling’s flash crash in early Asian trading before falling back below 114 currently. Sterling is the worst performer again today as markets continue to give a huge thumbs down to Chancellor Kwarteng’s doubling down on more tax cuts ahead (see below). Cable traded at a new all-time low earlier near $1.0350 before bouncing to $1.0725 currently. Sterling bears are talking about parity. We concur. USD/JPY is creeping higher to trade near 144 as the BOJ refrains for now from another round of intervention. The euro remains heavy in sympathy with sterling and traded at a new cycle low near $0.9555 before bouncing to $0.9640 currently. With Italy back in the spotlight (see below), our next target is the psychological $0.90 level. After that is the February 2002 all-time low near $0.8565. The combination of ongoing risk off impulses and repricing of Fed tightening risks is likely to keep the dollar bid across the board near-term. With the outlook for the rest of the world still worsening, the global backdrop continues to favor the dollar and U.S. assets in general.


Risk sentiment remains under severe pressure as the new week begins. Markets were already nervous last week as major central banks tightened aggressively but the huge fiscal policy mistake from the U.K. added further fuel to the fire. MSCI World tumbled -5% in its worst week since mid-June and is adding to those losses today. With global growth also slowing significantly, the backdrop for risk assets remains challenging. We expect the dollar to continue strengthening in this environment even as Fed tightening expectations remain elevated.

Markets are still digesting last week’s hawkish FOMC decision. WIRP suggests another 75 bp hike is almost fully priced in for November 2, as is a follow-up 50 bp hike December 14. Elsewhere, the swaps market is pricing in a terminal rate of 4.75%. As a result, U.S. rates continue to rise. The 2-year yield traded near 4.35% today, the highest since 2007, while the 10-year yield traded near 3.82% Friday, the highest since 2010. The real 10-year yield traded near 1.40% today, the highest since 2010. This generalized increase in U.S. yields is likely to continue and will ultimately support the dollar. Of note, the 3-month to 10-year curve remains positively sloped near 61 bp, the steepest since July, and so we are not yet ready to call for an imminent recession in the U.S.

Many Fed officials will spread the hawkish message this week. All are expected to hew to the hawkish stance, though Powell did note that there was a “fairly large” group on the FOMC that saw 100 bp of tightening by year-end vs. the 125 bp median. As such, there may be some modest hints of dovishness but make no mistake, this Fed is serious about getting inflation back to target. Collins, Bostic, Logan, and Mester speak today.

August Chicago Fed National Activity Index will be reported. It is expected at 0.23 vs. 0.27 in July. If so, the 3-month moving average should rise to 0.08 vs. -0.09 in July and would show continued resilience in the US economy. Recall that when that 3-month average moves below -0.7, that signals imminent recession and we are still well above that threshold. Negative readings indicate the economy is growing below trend and that is what the Fed wants. Still, many fear a hard landing and so we need to keep an eye on this data series as well as the U.S. yield curve. At 50 bp, the 3-month to 10-year curve is the steepest since July and above the cycle low near 21 bp from August. While this move higher is welcome, the risks of eventual inversion still remain high.

We get some key survey readings this week. Regional Fed manufacturing survey for September will wrap up. Dallas reports today and is expected at -10.0 vs. -12.9 in August. Richmond reports Tuesday and is expected at -11 vs. -8 in August. Chicago PMI will be reported Friday and is expected at 51.8 vs. 52.2 in August. Last week, preliminary September S&P Global PMIs came in higher than expected and moved closer to the ISM readings, which are more upbeat.


U.K. assets remain under pressure as Chancellor Kwarteng poured more gasoline on the fire. We cannot think of another instance like this in recent history where the markets have given an instant and unmistakable thumbs down to a policy announcement. And yet despite this, Kwarteng doubled down on his tax cuts and said over the weekend that “There’s more to come,” confirming U.K. press reports that the government plans to introduce even more tax cuts in 2023. As we noted last week, this is a huge gamble for Prime Minster Truss. While tax cuts may play well with Tory supporters, the general population may not be so keen on these cuts if they lead to an even deeper economic crisis. A poll released Sunday gave opposition Labour a 12-point lead over the ruling Tories and a seat-by seat analysis showed Labour on course for a 56-seat majority at the next election, which must be called by January 2025.

Bank of England tightening expectations have picked up as a result of the worsening situation. Is there anything the BOE can do to support the pound? They just met last week and hiked a lackluster 50 bp but would 75 or 100 bp really have made much difference? Sentiment was already poor but the tax package simply poured gasoline on the fire. We don't think any sort of emergency BOE rate hike would do much to support the currency beyond a brief knee-jerk reaction. Judging by past sterling crises, the scale of monetary tightening needed to truly stabilize the currency is likely much higher than the bank is willing to go at this point. For instance, the bank hiked rates to 15% leading up to Black Wednesday before its efforts to support the pound failed. As it is, WIRP suggests a 125 bp hike is fully priced in for November 3 while the swaps market is pricing in a peak policy rate near 6.25% over the next 12 months, up from 4.5-4.75% at the start of last week. Yet this has done nothing for sterling. Market confidence, once lost, is always difficult to regain.

Italy is likely to become more of a market focus in the coming weeks. As the polls suggested, preliminary results show that the right-wing coalition led by Brothers of Italy party won the most seats in parliament with 44% of the vote vs. 26% for the center-left coalition led by the Democratic Party. Brothers of Italy leader Giorgia Meloni will thus lead the next government. She has taken pains to assure the markets that she will continue orthodox policies. Her first major task is to draft a budget plan to be submitted to the European Union and to parliament this fall and approved by year-end. However, markets are not in a forgiving move and so any hints to the contrary should see Italy come under pressure similar to the U.K. As it is, we believe the right-wing coalition will have the same difficulties passing structural reforms as Draghi’s technocrat government did. To make matters worse, the ECB is expected to tighten policy aggressively even as Italy slips into recession. We expect further upward pressure on Italian yields in the coming weeks.

Indeed, ECB tightening expectations remain heightened. WIRP suggests another 75 bp is almost fully priced in for the next meeting October 27, while the swaps market is pricing in 250 bp of tightening over the next 12 months that would see the deposit rate peak near 3.25%, up from 2.75% at the start of last week.

Germany reported a weak September IFO business climate survey. Headline came in at 84.3 vs. 87.0 expected and a revised 88.6 (was 88.5) in August. This reflected significant drops in both current assessment and expectations to 94.5 and 75.2, respectively. Indeed, the expectations component is nearing the pandemic low of 71.9 from April 2020. October GfK consumer confidence will be reported Wednesday and is expected at -39.0 vs. -36.5 in September. France and Italy report September consumer confidence Thursday. We expect all eurozone confidence measures to continue deteriorating as we head into the fall and winter.


Bank of Japan Governor Kuroda said he supported last week’s FX intervention. Specifically, he said “The intervention was conducted by the finance minister’s decision as a necessary means to deal with excessive moves and I think it was appropriate. The intervention and monetary easing are complementary.” Yet we know that is not entirely true. By maintaining ultra-loose policy, the bank will only encourage further yen weakness. BOJ intervention may introduce more two-way risk in the FX market but it cannot reverse the weak yen trend. Only a pivot to a less dovish stance can do that and it’s clear the BOJ is not ready to do that yet. Indeed, we see steady policy through at least the end of Governor Kuroda’s term in April. Of note, reports suggest that the size of the intervention on September 22 was around JPY3.6 trln ($25 bln).

Japan reported firm preliminary September PMI readings. Manufacturing came in at 51.0 vs. 51.5 in August, services came in at 51.9 vs. 49.5 in August, and the composite PMI came in at 50.9 vs. 49.4 in August, the first sub-50 reading since February. The economy is slowly recovering as it reopens but domestic demand is spotty even as external demand weakens. As such,, it’s likely that we will see the composite fall back below 50 again soon as the indicators flirt with recession in the coming months.

China continues to take small measures to support the yuan. The PBOC announced a so-called risk reserve requirement of 20% on forward FX trades. This makes is more expensive for banks to buy foreign exchange via forwards or options and the PBOC has used this tool before to try and limit yuan weakness. When all is said and done, however, the primary driver for the yuan is the further widening of intertest rate differentials in favor of the dollar. Not only have foreign inflows dried up, but domestic outflows have picked up. Until the monetary policy divergences turn, the yuan will weaken further.

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