Mini-budget, maxi-problems.

The third quarter ended in gloom with markets concerned about the economic situation, inflation and rising interest rates. The Dow Jones had its lowest closing since November 2020 and the Nasdaq had the lowest since July 2020. Government bond yields continued to rise in September: the US 10-year rose from 3.2% to almost 4%, with the two-year rate following a similar rise, about 40 basis points higher.

The PCE price index released last Friday did not help to ease the tension. The PCE is the Fed’s preferred index to gauge inflation because it measures the change in prices of goods and services purchased by individuals for consumption, excluding food and energy. The PCE index rose by 0.3% in August, more than the 0.2% expected by analysts. US inflation slowed year-on-year in August, but accelerated again over a month. In the eurozone, inflation reached a new high in September at 10% compared to 9.1% the previous month. Persistent inflation is providing an argument for further central bank rate hikes to slow the economy. But the line between a slowdown and a recession is becoming increasingly blurred, which is scaring market participants and amplifying the fall in stocks.

In the UK, three weeks after taking office, new Prime Minister Liz Truss and Chancellor of the Exchequer Kwasi Kwartang caused a wave of discontent and even panic in the financial markets when they presented their mini-budget. This included a freeze on energy bills and a reduction in taxation for the richest 5% by removing the 45% tax bracket for incomes over £150,000. This was tax giveaway costing around £45 billion and which was to be financed by more debt. Clearly the market did not like it and sent the British currency to its all-time low against the dollar (i.e. since 1792, when the dollar came into existence...). Sovereign bonds have seen their yields reach their highest level since 2008 and falling valuations have led to huge margin calls on UK pension funds. To cope, the funds have been forced to trigger forced sales of Gilts and thus to fuel the decline even further. In order to safeguard the pension fund system, the members of the Bank of England decided urgently to suspend the “Quantitative Tigthening” and to set up a sovereign bond purchase programme aimed at curbing the rise in yields. This decision, which is intended to be temporary, is also intended to curb the rise in mortgage borrowing and avoid a housing market crash. And on Monday, the UK government reversed its decision on income tax. This turnaround and the support of the Bank of England has allowed the pound to recover all of its recent losses: from its low of 1.0350 on 26 September to 1.1450 this morning this represents a rise of more than 10% which brings the currency back to its mid-September level. At 1.1250 this morning, the GBP/CHF pair is back to its September 8 level, taking advantage of the Swiss franc’s weakness to climb back above 1.1200.

Apart from the ups and downs of the British pound, the new quarter is starting in risk-on mode: short-term bond rates are falling (the US 10-year has fallen back to 3.65%), equity markets are rebounding (+3 to +5% on the indices over the last five days), and safe havens such as the dollar and the Swiss franc are falling back: the euro-dollar is once again approaching parity, and the EUR/CHF has risen from 0.94 to 0.98. Even the VIX, the volatility index, is falling. Why? The renewed risk appetite may come from a desire by traders to attempt a rebound after an unfavourable quarter and capitalise on excessive short-term market pessimism and oversold indices (which is no guarantee of a rebound!). Another factor was the poor US manufacturing PMI data which came in below expectations. Paradoxically, this fundamental bad news could be interpreted as a sign that the Fed’s action is beginning to bear fruit and could finally slow down the rise in prices. People are trying to see the glass as half full and find reasons for hope even in bad news. The Australian central bank, by raising rates by only a quarter of a point instead of half a point, has sent a dovish signal that gives hope to those who are waiting for a shift in Fed policy (the term “pivot” is increasingly being used in the media).

In other news, oil is rising as OPEC+ members consider cutting production to support prices. Gas is down since the sabotage of the Nordstream pipelines as we seem to be heading into a mild winter in Europe. And lastly, Elon Musk has once again changed his mind about Twitter. With two weeks to go before the trial, the billionaire finally decided to buy the social network at the price agreed last April (a $44 billion transaction). Twitter stock jumped 22% on the stock exchange yesterday following the announcement.