Three Questions: Week of October 15

Good morning, and welcome to Three Questions - a look at the big uncertainties facing currency markets in the week ahead.

Here are some of the things we'll be watching:

1. Will political bloodletting lift the pound?

After the fifth-shortest tenure in the history of his office (two of his predecessors died during their terms), Kwasi Kwarteng is now an ex-exchequer who lost at Chequers. He was fired yesterday after a proposed package of tax-cuts—projected to cost 2 percent of GDP—prompted a disastrous backlash from financial markets and forced Prime Minister Elizabeth Truss into an embarrassing policy reversal. While the fiscal outlook has improved marginally, we don’t think currency markets will be placated by the Chancellor’s departure.

Stagflation fears are stalking the country. Investors expect inflation—now running at 9.9 percent year-on-year—to remain well above target in the months ahead as higher energy costs and a weaker pound raise prices across most household spending categories. The UK economy shrank 0.3 percent in August, and most economists think output will continue contracting well into 2023.

Beyond stagflation, the pound and gilts have been battered by the reminder that the UK has a structural twin deficit problem and no coherent plan to address it.

The UK was running a current account deficit of 5.5 percent of GDP and a budget deficit approaching 5 percent of GDP in the quarter BEFORE the latest fiscal splurge. Investors welcomed an expensive energy-price cap as a necessary inflation-fighting measure, but pressure for spending cuts is mounting - and these might hurt growth.

The Bank of England has restored relative calm in gilt and currency markets, but Governor Andrew Bailey has warned that government debt purchases are ultimately inconsistent with the need to fight inflation with rate increases and quantitative tightening. If concerns about pension-fund exposures resurface, such support measures could be extended, but the clock is ticking.

And the political backdrop is poisonous. Markets have lost confidence in Truss, but she could be hard to unseat. Even if the Tories somehow raise their third PM in as many years, the party is internally divided, it is 30 points behind in the polls, and the next election is most likely two years away.

With no palatable choices, the pound could linger in purgatory for longer.

- KARTHIK SANKARAN, SENIOR MARKET STRATEGIST

2. Could housing trip up the Fed?

The coming week will bring data on US existing home sales and prices, mortgage applications, housing starts, and building permits. Housing has remained relatively robust despite this year’s shocking 4 percent rise in mortgage rates, and markets expect a gentle deflation of the real estate sector to continue.

The biggest reason for this optimism—or complacency—is that the US is unique in offering households long-dated fixed rate mortgages with an easy refinance option. American homeowners can chase mortgage rates down and reduce their outlays—or extract home equity—and do so repeatedly at low cost. But they are relatively immune to the impact of rising rates, compared to their counterparts in countries where mortgages float or reset higher.

Higher rates do impact housing by chilling activity—mortgage applications and home sales typically drop, along with starts and building applications. But seasoned observers say prices can take much longer to adjust lower. The post-2008 housing market has been characterized by constrained construction activity, tighter credit requirements, and more limited issuance of the adjustable-rate mortgages that have shown themselves to be time-bombs disguised as teasers. Higher rates may be felt in employment in construction and household durables, but the financial accelerators are less potent than they used to be.

Today’s housing market might be less sensitive to rising rates—and represent a smaller systemic risk—than in the run-up to the global financial crisis in 2007. But the appearance of stability could lure Fed officials into a trap, convincing them to overtighten. Some policymakers, considering post-pandemic price moves unsustainable, could wait until a sharper drop in home prices before pausing rate hikes. Others might assign too much importance to the “owners' equivalent rent” component of the consumer price basket, which tends to exhibit an extremely delayed reaction to changes in home values. Finally, it is possible that a slowly deflating housing market characterized by high rates, low affordability, and low turnover volume increases demand for rentals, and in measured inflation.

An overly housing-dependent Fed response function could yet lead to a significant rise in unemployment that increases distressed sales, raising wider systemic risk. This could be something to watch over the course of 2023 and 2024.

- KARTHIK SANKARAN, SENIOR MARKET STRATEGIST

3. Will Xi's third term usher in a course correction?

The twentieth National Congress of the Chinese Communist Party that begins this weekend is virtually certain to cement Xi Jinping’s role as the country’s paramount leader. With markets long prepared for such an outcome, investors will focus instead on any evidence of a change in the government’s “zero-covid” policy, its growth strategy, or its approach.

In recent months, a number of reports suggested that pandemic-control policies would rely less on hair-trigger lockdown strategies once the party conclave comes to its conclusion. Yet a slew of articles carried by official outlets in recent days has suggested that any easing will be incremental at best. Reliance on local vaccinations—and newly developed inhalants—is likely to continue, and efforts to increase coverage will intensify. Any exit from the government’s draconian approach will likely be slow, which would also limit the rebound in consumption.

The troubles of the real estate sector have weighed on growth all year and Chinese authorities are likely to signal a greater willingness to backstop the sector as they seek to limit financial and political instability. They may also telegraph gradual (albeit insufficient) efforts to expand the safety net.

The big push is likely to come elsewhere, with a more challenging international context dominating discussion. Last week’s dramatic escalation of US sanctions and export controls against China’s technology sector creates a new arena for stimulus as the government seeks a more autarkic path. This could boost gross domestic product numbers but is unlikely to do much for the quality of growth—for decades, the most dynamic sectors of the economy have been outward- rather than inward-looking.

A similar logic applies to personnel announcements. Markets have been hoping that a prominent role for officials like Wang Yang on the Politburo Standing Committee would signal a more pragmatic turn. But Xi’s own preferences, his power, and a more threatening global environment are likely to keep the state at the commanding heights of the economy.

After a long wait, the National Congress could offer cyclical relief, but is likely to disappoint anyone hoping for structural change.

- KARTHIK SANKARAN, SENIOR MARKET STRATEGIST

CATALYSTS

TUESDAY

CAD Housing Starts, September

WEDNESDAY

GBP Consumer Price Index, September

CAD Consumer Price Index, September

USD Department of Energy Weekly Inventories

THURSDAY

USD Weekly Jobless Claims

FRIDAY

MXN Retail Sales, August

CAD Retail Sales, August

USD Baker Hughes Weekly Rig Count

COUNTERPARTIES

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