Sterling Gains from Kwarteng U-Turn are Fleeting

October 03, 2022

Win Thin

This is a big data week that could help determine whether the Fed needs to be even more aggressive; ISM manufacturing PMI will be today’s highlight; this is another heavy week of Fed speakers; Brazil goes to a runoff October 30
U.K. Prime Minister Truss finally blinked; despite the reversal on the top tax rate, the bulk of the fiscal plan remains intact; eurozone final September manufacturing PMI came in soft; Israel is expected to hike rates 75 bp to 2.75%; Turkey reported September CPI
BOJ Q3 Tankan report came in a bit soft; USD/JPY is creeping higher to trade at the highest level since intervention last month

The dollar is firm as the new quarter gets under way. We believe that some rebalancing flows may have been behind some of these counter-trend FX moves that we saw this week. Once these flows subside, we believe the upward dollar trend will resume in force. DXY is up modestly today after three straight down days and trading near 112.307. We expect an eventual test of last week’s new cycle high near 114.778. Sterling traded as high as $1.1280 today on news that the elimination of the top income tax rate was reversed (see below) but we see limited upside as the bulk of the fiscal plan remains intact. With policymaking credibility in tatters, we look for an eventual test of last week’s new all-time low near $1.0350. The euro remains heavy and is trading near $0.9870. We look for an eventual test of last week’s new cycle low near $0.9535. USD/JPY traded near 145.30 today, the highest level since BOJ intervention last month. This move higher should continue as markets test the BOJ’s resolve (see below). 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.

AMERICAS

This is a big data week that could help determine whether the Fed needs to be even more aggressive. Data last week showed the U.S. economy is proving to be more resilient and inflation more persistent than previously anticipated, which should keep the Fed in tightening mode. The price action in the FX market last week was a bit strange and may have been impacted by month- and quarter-end rebalancing flows. This week should give a cleaner read of the markets and we expect the dollar to resume its broad-based climb.

ISM manufacturing PMI will be today’s highlight. Headline is expected at 52.1 vs. 52.8 in August. Employment is expected at 53.0 vs. 54.2 in August while prices paid is expected at 52.0 vs. 52.2 in August. ISM services PMI will be reported Wednesday, with headline expected at 56.0 vs. 56.9 in August. Last week, Chicago PMI came in weaker than expected at 45.7 vs. 52.2 in August and was the lowest since June 2020. August construction spending (-0.3% m/m expected) and September vehicle sales (13.55 mln annualized) will also be reported.

This is another heavy week of Fed speakers. Bostic and Williams speak today. Fed officials last week remained largely hawkish, though some (Brainard and Daly) did express caution on the Fed moving too fast. WIRP suggests nearly 70% odds of a 75 bp hike November 2, which we think is a done deal after last week’s data. Looking ahead, the swaps market is pricing in a peak policy rate between 4.50-4.75%.

Brazil goes to a runoff October 30. Current President Bolsonaro won 43.7% of the vote and trailed former President Lula with 47.9%. The vote seems to have been completed with a minimum of disruptions. Despite recent polls suggesting Lula might get 50% support in the first round, we think most were resigned to a runoff vote October 30. The big question is how Bolsonaro ultimately reacts to the outcome. Does he claim fraud or does he accept the results? We won’t know until after the second round vote. As a result, we think investors will remain cautious for the next 4 weeks, especially as Lula’s margin of victory was much narrower than expected. If Lula eventually wins without any problems from Bolsonaro, we could see a relief rally.

EUROPE/MIDDLE EAST/AFRICA

U.K. Prime Minister Truss finally blinked. After refusing to budge, the plan to cut the top tax rate was withdrawn. Chancellor Kwarteng announced the decision and said “we get it, and we have listened.” He said the decision to scrap the top 45% income tax rate had become a “distraction.” Of note, it appears Truss is preparing to throw Chancellor Kwarteng under the bus if the need arises. Over the weekend, she said that the decision to eliminate the top tax rate was not hers but Kwarteng’s and that he did so without discussing it with her Cabinet. Truss acknowledged that her government should have “laid the ground better” but stressed that “I do stand by the package we announced.” Until today, it seems.

We note that despite the reversal on the top tax rate, the bulk of the fiscal plan remains intact. That is, all of the other portions of the plan remain unfunded even as the credibility of the nation’s top economic official is in tatters. Sterling rallied on the news of the reversal but has since given up much of those gains. The U.K. is entering a period of tremendous difficulty and the markets are left wondering whether policymakers are up to the challenge. Stay tuned.

Elsewhere, final September manufacturing PMI was revised down a tick from the preliminary to 48.4. Final September services and composite PMI readings will be reported Wednesday. Market expectations for BOE tightening have eased in recent days on the hopes that the fiscal plan will be reversed. WIRP suggests a 125 bp hike is nearly priced in vs. 150 bp last week, while the swaps market is pricing in a peak policy rate near 5.75% vs. the cycle high near 6.25% last week.

Eurozone final September manufacturing PMI came in soft. Headline was revised down a tick to 48.4. Looking at the country breakdown, Germany was revised to 47.8 vs. 48.3 preliminary, while France was revised down a tick to 47.7. Italy and Spain were reported for the first time and came in at 48.3 and 49.0, respectively. Final September services and composite PMI readings will be reported Wednesday. ECB tightening expectations remain elevated as a 75 bp hike October 27 is nearly priced in while the swaps market is pricing in a peak policy rate near 3.0%.

Bank of Israel is expected to hike rates 75 bp to 2.75%. At the last meeting August 22, it delivered a hawkish surprise and hiked rates 75 bp vs. 50 bp expected. The bank noted that “The Israeli economy is recording strong growth, accompanied by a tight labor market and an increase in the inflation environment. The increase in inflation is broad-based, with contributions from most CPI components.” The hawkish message was received as the swaps market is now pricing in a terminal rate near 3.0%. At the previous meeting in July, bank researchers saw the policy rate at 2.75% in Q2 2023 but that rate path has likely steepened now. Updated macro forecasts will be released at this week’s meeting.

Turkey reported September CPI. Headline came in at 83.45% y/y vs. 83.50% expected and 80.21% in August, while core came in at 68.09% y/y vs. 68.60% expected and 66.08% in August. PPI accelerated to 151.50% y/y and points to further upside risks for CPI. Despite still-rising inflation, the central bank has cut rates by 100 bp for two straight meetings. Next policy meeting is October 20 and while the data do not support another cut, it’s clear that there is significant risk of a dovish surprise at every meeting. The lira should continue to weaken but the pace has been controlled as policymakers keep a tight grip on the exchange rate.

ASIA

The Bank of Japan Q3 Tankan report came in a bit soft. Large manufacturing index came in at 8 vs. 10 expected and 9 in Q2, while the outlook came in at 9 vs. 11 expected and 10 in Q2. The headline reading fell for the third straight quarter. Elsewhere, the large non-manufacturing index came in at 14 vs. 13 expected while the outlook came in at 11 vs. 15 expected and 13 in Q2. In a good sign for investment, planned large all-industry capex came in at 21.5% vs. 18.9% expected and 18.6% in Q2. After a soft start in July, the data have been coming in strong in August but the Tankan report suggests some headwinds are building. While the slowdown doesn’t appear to severe, it’s clear policymakers are proceeding cautiously. Elsewhere, final September manufacturing PMI came in at 50.8 vs. 51.0 preliminary.

USD/JPY is creeping higher to trade at the highest level since intervention last month. Data Friday showed the BOJ spent nearly JPY2.84 trln ($19.7 bln) to support the yen and yet here we are back above 145 and nearing the September high near 145.90.. We do not think the BOJ can intervene regularly at that pace. Instead, it is likely to come in from time to time when the moves get disorderly and introduce more two-way risk. Simply put, the BOJ cannot hope to reverse the weak yen trend until it pivots away from its ultra-loose stance.

Brown Brothers Harriman & Co. (“BBH”) may be used as a generic term to reference the company as a whole and/or its various subsidiaries generally. This material and any products or services may be issued or provided in multiple jurisdictions by duly authorized and regulated subsidiaries.This material is for general information and reference purposes only and does not constitute legal, tax or investment advice and is not intended as an offer to sell, or a solicitation to buy securities, services or investment products. Any reference to tax matters is not intended to be used, and may not be used, for purposes of avoiding penalties under the U.S. Internal Revenue Code, or other applicable tax regimes, or for promotion, marketing or recommendation to third parties. All information has been obtained from sources believed to be reliable, but accuracy is not guaranteed, and reliance should not be placed on the information presented. This material may not be reproduced, copied or transmitted, or any of the content disclosed to third parties, without the permission of BBH. All trademarks and service marks included are the property of BBH or their respective owners.© Brown Brothers Harriman & Co. 2022. All rights reserved.