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UK gilt markets in focus as Hunt takes the reins

UK chancellor Jeremy Hunt

While European markets finished last week on the up, US markets did not, finishing the week lower, with the S&P 500 within touching distance of a key support level at 3,500.

This weak finish looks set to translate into a slightly lower European open against a backdrop of a negative start in Asia trading, which followed in the footsteps of last week’s weak finish in the US.

Markets can be a fickle beast, with Friday’s reaction to the news a classic case in point, after UK PM Liz Truss decided to go full reverse ferret on the recent mini-Budget, along with the departure of Kwasi Kwarteng as chancellor of the exchequer, to be replaced by former health secretary, Jeremy Hunt.

Gilt yields, which had been falling in expectation of that decision, rallied strongly once the decision had been confirmed, while the pound underwent a sharp slide, reversing some of its gains for the week.

There is little doubt that the government’s handling of recent events has been incompetent, even as some of the policies they were looking to implement could be easily justified. For instance, the decision to restore the corporation tax rise implemented by previous chancellor, Rishi Sunak, from next year is incredibly short-sighted, and one measure which really ought to have stayed.

I’m old enough to remember the incredulity and the protests when Sunak announced that he would be looking to raise corporation tax to 25% from next year a few months ago He was rightly criticised for raising taxes on business into the teeth of what was likely to be a significant economic slowdown and urged to think again. Business has had to contend with a great deal these past two years, with Covid-19 and now higher costs because of surging inflation, and now will have to contend with an even higher tax burden. As a result, this higher tax burden could be the difference between staying afloat and going under over the next two years, which is perhaps why Goldman Sachs downgraded its estimates for the UK economy, while forecasting a significant recession in 2023.

The big question now is whether the volatility seen in gilt markets in recent weeks settles down as we start a new week, and with the Bank of England’s gilt buying programme now officially at an end.

There is no question that recent events have shattered confidence in the UK current government, and trust once foregone is usually very difficult to get back. The wider question now is what happens next with respect to any new Budget, and whether new chancellor Jeremy Hunt can stabilise the ship at a time when global interest rates are rising anyway. Hunt is expected to make a statement later today outlining measures from the Medium-Term Fiscal Plan, with the intention to deliver the full details on 31 October.

Not only will any new Budget need to pass the smell test for everyone, global institutions as well as financial markets, but the wider question is whether the current government can even survive the next few days. A lot of that will depend on the internal wranglings within the Conservative party, which is a luxury the country can ill-afford. The party needs to get its act together, stop talking to itself and start talking to the country, and doing what it was elected to do, govern the country with something resembling competence.   

The backdrop of higher rates was reflected on Friday when US 10-year yields closed above 4% for the first time since 2008. The move higher here has in turn pulled global yields higher, as markets start to price in the potential for another two 75bps rate hikes by the Federal Reserve by year end. This is being reflected in US 2-year yields which are even higher at 4.5%.

Consequently, this is likely to raise the prospect of a more aggressive posture from the likes of the Bank of England, as well as the European Central Bank, if only to try and keep a floor under their currencies, to stem the inflationary impulse of a weaker currency.

It’s all very well for US President Biden to come out and criticise the UK government for their recent fiscal mistakes, as he did at the weekend, but he can’t get away scot-free as it was his own fiscal plans over a year ago that have caused a lot of the problems that are contributing to the current crisis. In an op-ed for the Washington Post in February 2021, the $1.9trn fiscal plans were heavily criticised by former US Treasury secretary Larry Summers as the “least responsible macroeconomic policy” in 40 years, while warning that the proposals could have “consequences for the dollar and financial stability”.

At the time the Biden administration pushed back against these inflation concerns, yet here we are now 18 months later, facing a surging US dollar and rising concerns over global financial stability, as the US central bank strives to tame the inflation genie that has been unleashed in the past few months. While many people are criticising the current government for the sharp rise in interest rates, given global events it’s not entirely a crisis of their own making.

As a counterpoint it is true that no one could have foreseen the impact of the Russian invasion of Ukraine, but even without that we can also see that the seeds of the current crisis were planted 18 months ago by the very same US administration now criticising others for their own fiscal mistakes.

EUR/USD – rebounded from the 0.9630 area last week, but is currently struggling to move above the 0.9800 area. The bias remains for further losses towards 0.9000, while below 1.0000. A break above parity and the 50-day SMA is needed to signal a short squeeze, towards 1.0200. 

GBP/USD – rebounded from 1.0920 last week but needs to get above the 1.1500 area to stabilise A move below 1.0920 opens up a return to the 1.0800 area.

EUR/GBP – last week’s decline found support at the 0.8600 area, while the inability to move back above the 0.8860 area saw a pullback. These are now the two key levels in terms of overall direction. We also have trend line support from the August lows and 100-day MA at 0.8560.

USD/JPY – broke above the 1998 highs and is now at its highest levels since September 1990 when it was trading as high as 152.30, and came down from highs of 160.20 in the summer of that year. The next target now sits at the 150.00 area. Support comes in at last week’s low at 145.15.

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