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Coupled with the cap on household energy bills, the fiscal easing now being delivered by the government is very significant - potentially adding 10 per cent of GDP to the debt burden, depending on the final cost of the energy bill freeze (Chart 1). Surprisingly, there were no accompanying Office for Budget Responsibility analysis and forecasts, which are now scheduled to be available before the end of the year.
Unfunded fiscal in an era of no QE and high inflation
The UK economy is already under huge pressure due to the energy price shock, rampant inflation (which is much broader in its composition than just the energy component), and the associated squeeze to real incomes. Though the fiscal stimulus to offset the burden on the household sector reduces the risk of a sharp slowdown in consumption through the winter, risks to the private sector have been transferred to the government balance sheet. The unveiling of across-the-board yet unfunded tax cuts against the backdrop of a highly constrained central bank (due to high inflation) has rightly led to investor concerns about debt sustainability and policy mix optimality.
The funding source of the fiscal package is an important variable in this cycle. All the major central banks are now fighting inflation partly driven by the very generous fiscal support offered during Covid, which at the time was more than fully accommodated through large-scale asset purchases. In the absence of this major source of demand for debt from central banks - some of which including the Bank of England and the Federal Reserve are in fact now selling their asset holdings, - any attempt to loosen fiscal policy through fresh borrowing by governments would, understandably, be met by investor concerns.
UK asset markets under extreme stress
Current market action in UK assets is a vote of no confidence in the government’s plans to boost growth.
Risk premia in UK assets are being priced in as the nature of the policy mix (i.e. significant fiscal easing during a time of high inflation and outsized external imbalances) is being questioned. Indeed, evidence of EM-like asset correlations (positive correlation across currency, bonds, and equities) had been building as expectations of fiscal easing started being processed by the market.
The BoE’s policy decision at the September meeting, a day before the “mini budget”, did not take into account the additional fiscal easing which had been preannounced and was already seen by the markets as a sub-optimal response vis-a-vis the Fed and the European Central Bank. Markets are currently pricing in 150bp of hikes by November and a terminal rate of nearly 6 per cent in 12 months’ time (Chart 2). It is now time for the BOE to step in to protect its credibility.
Chart 2: Markets are now pricing a UK terminal rate of 6%
Source: Bloomberg, Fidelity International
In the absence of a U-turn from the government, the BOE will have to hike rates aggressively from here. The slump in sterling is likely to make the exchange rate a more dominant driver of monetary policy from here, pushing the BOE to get policy rates meaningfully above the Fed base rate to stem the pressure on the currency through positive carry and help finance the very wide external deficit.
While in today's statement the BOE said it won't hesitate to change rates as needed, it has signalled it will wait until the November meeting to make a full assessment and act accordingly. In the current environment, the November meeting seems a long way away. We believe there is a significant chance of an inter-meeting policy intervention including at least a 100bp emergency rate hike and possibly swap lines with the Fed.
Given the high public and private debt burdens post-Covid (Chart 3), this sharp tightening in financial conditions raises the likelihood of an inflationary bust down the line where very high rates lead to balance sheet de-leveraging.
Chart 3: UK government debt as a % of GDP has nearly tripled over the past 20 years (latest available as of Q1 2022)
Note - Above debt numbers are based on non-consolidated data and have a wider scope than the consolidated debt figures. This includes data for other public sector bodies such as public corporations and the Bank of England. Source: Refinitiv, Fidelity International, September 2022.
Where to from here?
A fresh reassessment of the post-Brexit structure of the UK economy had been sorely needed. However, unfunded fiscal expansion without monetary accommodation puts a different complexion on the significant change in policy direction laid out by the new government. The sharp moves in UK assets, especially in sterling, against the backdrop of the generalised dollar rally have the potential to become disruptive and systemic, with spillovers already seen across broader markets.
Our Asset Allocation views have been cautious since March with underweights in equities and credit. Within equities, we have been underweight Europe versus the US. We have been positive on the dollar due to excess Fed hawkishness, but the current moves are looking disruptive and may lead to market interventions - a risk that bears close watching. While we do not believe a Plaza Accord 2.0 is imminent, unilateral interventions from the major central banks look likely. The Bank of Japan has already started to intervene to support the yen in light of its dramatic plunge in recent months and others could follow - the BOE might be next.