Once inflation starts to decline, bond yields and bank rates can stabilise. This will be a recovery moment for equities.

This year has been a remarkable and unprecedented one for investors. The strain of transforming from an ultra-low interest rate economy back to the type of monetary conditions we were used to prior to the global financial crisis of 2008 has been clearly evident in currency, equity and bond markets.

The policy mis-step by Kwasi Kwarteng around the smaller part of his mini budget which was aimed at fending off an expected recession, caused concern in international capital markets thar are now likely to cause more difficulties for the UK economy.

The new Chancellors mini budget came just days after the announcement of a comprehensive support package for households and business over energy costs. This package is likely to cost three times more than the cost of the tax cuts announced in the speech.

Markets had taken the debt funded energy support programme costing around £150bn positively and without a reaction to the value of sterling or gilt yields. The unfunded tax cuts worth in a loss of revenue to the treasury of around £45bn that were announced, took markets by surprise and caused a hit on sterling of 9% against the US$ and a fall in gilt prices of up to 15%. The falls were recovered once the Bank of England stepped in as lender of last resort. The BoE made a commitment to buy up gilts at a rate of £5bn per day for 13 consecutive days. A total of £65bn to underpin the gilt market. This intervention stabilised markets, allowing gilt yields and sterling to recover almost back to where they stood before Mr Kwarteng stood up.

It does seem at odds that the smaller programme of growth focused tax cuts should cause such an outsized reaction as compared to the far larger and open-ended commitment to energy costs for every household in the country.

The fact is that the energy price cap is seen as important to the economy and without it would cause hardship and business failure. The tax cuts were not essential and benefited the wealthy far more. The lack of published independent scrutiny of the proposals was not helpful either.

Due to the UK’s declining overseas trading volumes, the government relies upon foreign investors rather than our own domestic savers to buy up nearly all issued government debt. Because of this need to be supported by overseas investors, the perception of UK credit worthiness and risk is so important.

The impact of this recent gilt price volatility is one that impacts upon other financial assets that price off the so-called risk-free asset. Making UK gilts suddenly appear to be carrying risk has far reaching consequences as Rishi Sunak unsuccessfully warned about throughout the summer. Unfunded tax cuts do have implications.

The longer-term implications are that credit agencies will look at UK creditworthiness and think about downgrades. The cost of capital for UK home buyers and businesses will be higher than it otherwise would be, which in itself is a drag on spending and economic growth which is exactly what the new Truss government was aiming for with this mini budget.

One week on from the BoE intervention and the FTSE 100 was back to around 7000 points and sterling back to US$1.11 to the GBP.

It is not just the GBP that has weakened against the mighty US$ this year. All currencies have been devalued relative to the US$. The US$ is now stronger in relative terms than it has been for many decades.

Due to the strengthening of the US$ the draw on capital has been strong. The pull of money to the USA is leaving other countries under pressure to attract international capital. The result being that the values of the Euro, Yen, Renminbi and Sterling have fallen substantially.
As a result of a strong US$ and US treasury yields currently at 3.89%, the rest of the world is experiencing a shortage of cheap capital. When the UK government ask investors to buy UK gilts to fund our energy cap policy and unfunded tax cuts, the market reacted by wanting a higher yield. This further explains why markets are sensitive.

The US economy is far better insulated from recession than other nations. Despite the rises in US interest rates, US economic data is quite positive. Business and consumer confidence remain strong and spending is being maintained. The reason for the easing of US inflation is that oil prices are falling as is the cost of imported goods.

The Fed is still of a view that the US labour market is still tight. The Fed would like US unemployment to rise from 3.5% to around 4.5%. At that level of unemployment, the rate of wage inflation would be modest. The US jobs market created 315,000 new positions in August and then another 263,000 in September. There are no strong signs that new job numbers subsiding so we can expect US interest rates to continue for a while perhaps until a fall in new job numbers.

The one issue that all investors would like to see is US yields starting to fall. There are signs that US inflation has already peaked in June and that US inflation currently at 8.3% is now expected to fall to 7% in Q4 and then to 5.5% in Q1 and to 3.25% by Q2. After a period of aggressive rate tightening by the Federal Reserve, US interest rates currently stand at 3.25% and are expected rates to hit 4.5% with a 0.5% then 0.5% and a 0.25% rate rise at each of the next three Federal Open Market Committee (FOMC) meetings in November, December and January.

Once we are in position of declining inflation, bond yields and bank interest rates can then stabilise and begin to ease. This will be a recovery moment for equities. This could be the case in the USA in Q4 but not in the UK or Europe until Q1 or Q2.

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