31 October 2022: Taxes will have to go up

Taxes will have to go up

31st October: Highlights

  • How will Hunt avoid spending cuts?
  • The Fed may have little choice other than to bring about recession
  • Eurozone sentiment at a two-year low

GBP – Business confidence is at its lowest level since Covid

In a couple of weeks, Jeremy Hunt will present MPs with what it is hoped will be a carefully crafted plan to combat the gaping hole in the country’s finances.

Whatever he does, it is bound to be unpopular. Presenting a budget at a time when the economy is struggling always is, and introducing plans that give the financial market confidence that the economy will recover and grow always costs the man in the street, whether through reduced services or by higher taxation.

One issue yet to be decided is the triple lock on the state pension and whether the country can afford to increase benefits such as universal credit.

Increasing the State Pension in line with inflation will cost an extra five billion pounds, which Hunt must find elsewhere.

One plan that is being discussed is a freeze on foreign aid. The UK provides almost fourteen and a half billion pounds in foreign annually, with Ethiopia, Nigeria, Somalia, Afghanistan and Yemen receiving the most, according to 2020 statistics.

This is the equivalent of a family making charitable contributions when they must visit the food bank to feed themselves!

The increase in National Insurance Contributions that the Prime Minister introduced last April when he was chancellor has been cancelled and reintroduced so many times that Civil Servants are as confused as the public.

The latest news from Downing Street is that the 1.25% increase won’t be reintroduced. It is highly unpopular with the public and companies alike and will be kept in reserve in case it is needed if growth doesn’t pick up in the second half of next year.

This week, the Bank of England’s Monetary Policy Committee will meet, and the outcome will likely be a hike in the interest rate of fifty or seventy-five basis points.

Whatever the MPC decides, Andrew Bailey, the Bank’s Governor, will be almost apologetic when he delivers the news on Thursday.

Sterling has been buoyed by the renewed confidence that Rishi Sunak brought, although there was a feeling of any one by Truss pervading the markets prior to last Monday.

Sterling has started the week trading around 1.1600. A lot depends on how hawkish the MPC statement is following the rate hike, since there is no front-line data due this week.

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USD – FOMC targeting 5%

The Fed has been tightening interest rates since last March, and the effect on inflation has been negligible.

In hindsight, it would have been better if the FOMC had increased interest rates by one hundred points at three consecutive meetings since that would have meant rates would have become restrictive more quickly. It is clear, with hindsight, that the economy was sufficiently strong to stand such a move.

Some analysts rumour that the Fed is targeting a Fed Funds Rate of 5%. At the time of the last meeting, the forecast target was 4%. That shows that the Fed is still concerned about rising inflation.

At the end of the Pandemic, a lot was said about the reduction of the Central bank’s balance sheet, which would have reduced liquidity, thereby reducing the number of funds available to banks to lend to their clients.

The plan is for the Fed to either materially change the reduction or halt it entirely in mid-2023, although it doesn’t appear to have the desired effect on inflation.

While the Fed carries on tackling inflation, the chances of the economy slipping into a recession in the New Year have increased to about seventy-five per cent, according to several sources on Wall Street.

The first sign of the slowdown is expected to be seen this Friday when the October Employment report is released.

Last month the economy produced 263k new jobs, and anything above 200k in August will be considered positive. Economists at Bank of America have reported that they believe that new job growth will begin to decline from this report onwards and fall into negative during Q1’23.

The dollar index has begun the new week in positive territory, trading around 110.80. The major contributory factors are anxiety about what the Fed will do and say when it meets this Wednesday and a general feeling of risk aversion given Russia’s cutting off grain supplies leaving Ukrainian ports.

Due for publication this week is the ISM data for manufacturing output, which is expected to fall from 50.8 last month to 50 in October. This is yet another indication of the continuing but gradual slowdown in economic activity.

As part of the employment report, average earnings are expected to fall, which will be another element in the slowdown in creating new jobs.

EUR – Central Bank scales back support for financial markets

Christine Lagarde has cast the Russian President as a pantomime villain, commenting that Vladimir Putin is responsible for all that ails the Eurozone economy.

Putin halted the safe passage of grain supplies from Ukrainian ports in retaliation for a drone attack on the Russian fleet in the Black Sea Port of Sevastopol.

The measure will affect about nine million tonnes of grain shipments. It will almost certainly add to both shortages throughout Europe and the UK and to inflationary pressure in the economy.

Last week the ECB hiked interest rates by seventy-five basis points to 1.5%, having learned little from the Bank of England and the Federal Reserve. They expect to slow the inflation increase even though official rates are still accommodative.

It will take one or two more increases of that level to see inflation dented, and by that time, it is expected that the economy will be in recession.

This week sees the release of GDP data for the third quarter. Although it is not expected that the economy will have contracted between July and September, growth is expected to have fallen from 0.8% in Q2 to 0.2% most recently. This will lead to a year-on-year fall from 4.1% to 2.1%

Individual economies fared quite differently in Q3. France managed to eke out marginal growth, while Germany unexpectedly managed to beat expectations.

The unexpectedly hard-fought nature of the war in Ukraine has surprised many observers, as Ukrainian troops are not only managing to hold their own by are making gains on several fronts.

The longer the war goes on, the greater the chances are that NATO may get physically drawn into the conflict, with disastrous consequences for the region.

The euro has begun the new week treading water. Reaction to the predictable rate hike last week has been negligible, and no significant new positions will be created until traders are sure that the FOMC meeting later this week does not produce any surprises.

Have a great day!

Alan Hill

Alan has been involved in the FX market for more than 25 years and brings a wealth of experience to his content. His knowledge has been gained while trading through some of the most volatile periods of recent history. His commentary relies on an understanding of past events and how they will affect future market performance.