A highly volatile Q3 for markets has drawn to a close leaving behind a deeply inverted US yield curve, stronger dollar and lower equities. The rapid regime shift away from ultra-low interest rates and asset purchases in response to high inflation is largely driving market volatility, but as developments in the UK gilt market have demonstrated there are also spillover effects coming into play.
UK policy remains in the spotlight
Concerns over the viability of the fiscal and monetary policy mix in the UK continue to amplify volatility in global markets. The government this week reaffirmed its intentions to press ahead with expansionary fiscal measures despite adding to the inflationary outlook, drawing the ire of the IMF. The repricing in the gilt market to much higher yields that came off the back of this uncovered insolvency risks in the UK's large pension fund sector, prompting intervention from the Bank of England. Daily gilt purchases (up to £5bn) directed at long-dated maturities (20yrs and above) are set to take place through to 14 October, effectively giving time for funds to reposition their exposures to account for higher interest rates going forward. All up, this implies a £65bn operation.
Following the mini-budget, the UK's Debt Management Office announced the measures would require an additional £62bn of gilt issuance for the fiscal year. On top of that, the BoE had last week given the green light to start its gilt sales program, totalling around £40bn over a 12-month period. As part of this week's announcements, the BoE has said it will now delay gilt sales by 4 weeks until the end of October. However, the BoE is still formally targeting an £80bn reduction in its balance over the next 12 months, though those plans are now clouded by uncertainty. BoE Chief Economist Huw Pill said this week the MPC was not in favour of hiking rates over the inter-meeting period, but that a "significant monetary policy response" looks warranted at the November meeting in light of the government's fiscal stimulus plans.
US inflation reaccelerates
After seeing some respite in July, US inflation pressures lifted in August as the Fed's preferred core PCE deflator rose from 4.7% to 4.9%yr, above the 4.7% pace expected. There was better news on the headline PCE measure, which has eased to its slowest since January at 6.2% reflecting declining gasoline prices. However, for the Fed, it is the core rate that is most influential for policy, and August's upside result supports the hawkish message from FOMC members during the week, including from the Vice Chair Lael Brainard in giving backing to restrictive monetary policy settings to return inflation to target.
High inflation and the Fed's rapid hiking cycle have been headwinds to US consumers, but while demand has slowed since the beginning of the year it continues to hold up. Year-ended growth in personal consumption has moderated to 1.8%, an 18-month low. While that situation should help to ease inflation pressures, the composition of demand is now being driven entirely by services, a component in which inflation tends to be stickier than for goods. With the effects of the pandemic dissipating and consumption patterns continuing to rotate back to services, this may slow the pace at which inflation comes down.
More signs of resilience from Australian households...
The data points over the past week reaffirmed the resilience of the Australian economy to headwinds domestically and offshore. Retail sales posted their 8th consecutive month-on-month gain rising by 0.6% in August, an upside outcome on market expectations for 0.3%. The picture for discretionary spending was softer than the headline result as sales ex-food saw a 0.3%m/m rise, but that is against the trend of what has played out so far this year, with discretionary spending far outpacing headline retail sales.
Although weak financial markets and falling property prices contributed to a reported 3.3% decline in aggregate household wealth in the June quarter, a strong labour market has been key in driving incomes and supporting spending. Job vacancies came in lower for the 3 months to August (-2.1%), but that looks consistent with other data that have indicated activity in the labour market slowed around the middle of the year due largely to seasonal factors and Covid disruptions. The key point remains that vacancies, both in absolute terms and as a share of the labour force, are very elevated, which points to a further tightening in the labour market via a lower unemployment rate.
... could lead the RBA into another 50bps rate hike
The strength in the labour market and a very favourable terms of trade position on the back high commodity prices are key factors that narrowed the deficit in the Federal Budget for 2021/22 by $47.9bn from the earlier forecast to 1.4% of GDP. The RBA returns to the fold next week where markets lean to another 50bps hike in rates. My reading of the ABS's new inflation gauge suggests headline inflation is running around 7% in Q3, up from 6.1% in Q2 and is seemingly broadly consistent with the RBA's outlook for inflation to rise to the high 7s by the end of the year. The RBA has been openly discussing the idea of downshifting to hiking in 25bps increments, though the global backdrop of volatile markets and central bank credibility coming under pressure may make this difficult for the Board to pull off next week.
Euro area inflation hits 10%
The euro area's deepening energy crisis drove stronger than expected inflation readings in September risking another 75bps rate hike from the ECB at the October meeting. Headline inflation lifted from 9.1% to 10%yr (vs 9.7% expected) and the core rate now stands at 4.8% (vs 4.7%) from 4.3% in August. The increase in energy prices over the year is almost 41%, pressures which are feeding through to push up prices of goods and services across the economy, seen in the core rate running well above the ECB's 2% target. Speaking before the European Parliament this week, ECB President Christine Lagarde said that rate hikes "over the next several meetings" are likely to be needed to guard against inflation expectations becoming deanchored.
