by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Good morning.  Markets are higher this morning, with U.S. equity futures moving higher before the PPI data.  The PPI data came in “hotter” than expected, taking equity futures off their earlier highs.  The dollar is mixed, with the GBP modestly higher while the JPY is lower (and in the area that has triggered intervention recently).  We expect a mixed trade today in front of tomorrow’s CPI data.

In today’s Comment, we begin with economic and finance news by trying to answer the question: what on earth is Andrew Bailey trying to do?  The Ukraine War update follows, China news comes next, and we close with the international roundup.

Markets, Economics and Policy:  BOE Governor Andrew Bailey has rocked the financial markets with inconsistent statements, so we will attempt to parse out what is going on with the U.K. central bank.  The IMF is meeting, and its forecast is dour.

• Yesterday, in an interview, BOE Governor Bailey surprised the markets by indicating that the emergency funding for the Gilt market would end on Friday, full stop. He warned the markets that they had “three days left.”  This declaration contradicted earlier statements suggesting that support would be extended.  Financial markets reacted immediately as the GBP plunged, equities sold off, and long-duration yields, not just on Gilts but Treasuries too, rose.
• And yet today, Bailey apparently signaled that the BOE will probably continue to support the Gilt market.
• So, how do we make sense of this?
  • First, a quick recap of how we got here. The U.K. was facing higher inflation.  Then PM Truss issued her fiscal plans, which included what was essentially a large fiscal spending program.  Gilt yields jumped.
  • Whenever interest rates rise sharply, financial stability is at risk. And, in our experience, where the “cracks” appear is often a surprise.  In the U.K.’s case, the initial stress emerged in the pension market.  Pension funds have long-term liabilities since members will age in a few decades and so the funds try to match that liability with a similar long-dated asset.  When interest rates fell to zero, meeting these long-term liabilities became a challenge.  And so, to offset this risk, the funds engaged in derivatives which would pay them if interest rates fell further.  For this to work, of course, leverage was employed.
  • When interest rates rose, it was actually good news for the pension funds, because it became easier to fund their long-dated liabilities. However, these derivatives, which, to remind, protected from falling rates, were triggering margin calls as rates rose.  This situation is what we call the “hedger’s dilemma.”  The long term cash position in an adverse market action actually improves, but in the short run, the derivative demands for immediate cash must be maintained to continue to hold the hedge position.  So, to provide cash to meet margin calls, pension funds started dumping Gilts, sending their yields higher and essentially creating a “doom loop.”
  • Here is where the BOE enters the picture. To stabilize the Gilt market, Governor Bailey offers a short-term buying plan to provide a market to break the doom loop.
• However, the pension crisis has created a policy dilemma for Bailey. He is facing the “Tinbergen problem.”  Jan Tinbergen[1] postulated that policy makers need an equal number of policy tools for an equal number of policy problems.  Otherwise, the policymaker is forced to choose which problem to resolve and let the other go untouched.  Bailey needs to simultaneously address an inflation problem which demands higher rates and also a financial stability problem, which requires easier policy.  So, this is how he is trying to manage this dilemma:
  • The BOE has offered to buy Gilts, but the offer doesn’t have a set price. If a pension fund wants to sell Gilts to the BOE, it makes an offer, but the bank can refuse to buy at that price.  What Bailey is trying to avoid by this policy is a resumption of QE.  This is why so few bonds have actually been sold.  The deal being offered isn’t that attractive to pension managers mostly because they have no transparency on whether or not they can actually get liquidity.  Thus, most of the transactions are occurring in the market.
  • Essentially, what the BOE is trying to do is protect the functioning of the Gilt markets without signaling to the Truss government that the bank is monetizing her spending. It’s a bold strategy…
• The BOE’s problem is a cautionary tale for all central bankers. In an inflationary environment coupled with excessive leverage, a byproduct of years of ZIRP, central bankers will almost certainly be facing similar problems in the future.  The whole talk of the “Fed pivot” is mostly based on this dilemma.  The pivot argument rests on the notion that when faced with combatting inflation or financial instability, the Fed will choose the latter, flooding the markets with liquidity and leading to rallies in risk assets.  We see two issues with the pivot argument.  The first is that the Fed (or other central banks) may not choose stability; in that case, the downside in risk assets could be much more severe.[2]  The second is that the flooding of liquidity may not lead to the rally in risk assets, but a currency crisis (as we are seeing with the strength in the dollar).  Thus, the BOE situation is a cautionary tale that is almost certain to be repeated elsewhere.
• The IMF offered a downbeat forecast for the global economy that actually reflects what is occurring in the U.K.’s Policy tightening, China’s Zero-COVID policy, and the Ukraine War are creating a toxic mix that will depress economic growth, trigger higher prices, and raise financial stress.
• The Biden administration has proposed rule changes to “gig workers” that, if accepted, could undermine the business models of companies that provide platforms for such workers. Essentially, the rules would turn more of these workers into employees, forcing firms to provide benefits that they currently don’t offer.  Shares in such companies slid on the news.
• Railroad workers rejected a tentative agreement, brokered by the Biden administration, increasing the chances of a national rail strike. The railroad industry has become increasingly concentrated in the past decades, leading to stronger profit margins but also making the system more vulnerable to labor action.  A nationwide strike will put the administration in a difficult spot.  If they support the unions, it could paralyze the economy and lead to higher inflation from panic buying, but if it steps in and forces the workers back on the job, they could lose political support from the unions.
• High frequency data suggests imports plunged in September. This may reflect production problems in China but may also be tied to falling American consumption.  One of the signals of recession is falling imports.
• Inflation expectations survey data from the NY FRB suggests that inflation is expected to moderate over the next year, but the three-year expectation did tick modestly higher.
• The federal deficit fell by $1.4 trillion in fiscal year 2022 (which runs from November to October) as pandemic spending eased and tax revenue increased. This drop is actually fiscal tightening, one of the overlooked bearish factors for the economy.
• As the dollar rises, the JPY is once again at similar levels to where the BOJ had decided to intervene last month. The strong dollar is also creating a boon for Americans traveling abroad.
• One of the problems with regulation is a process called “regulatory capture.” The longer a regulatory body exists, the greater the odds that the group being regulated comes to dominate the regulator.  This occurs for a couple of reasons.  First, all the data to regulate the industry comes from the companies in that industry, and so to obtain the necessary information, the regulatory body must have good relations with the firms.  Second, if a regulator wants a job in the private sector at some point, they will almost certainly go to work with a firm they have regulated.  This problem is known as the “revolving door.”  Recent investigations, however, suggest the problem runs even deeper since regulators are often investing in the firms they regulate, further leading them to side with the companies they are supposed to be monitoring.
• Apartment demand is falling rapidly as rents rise.
• BNY Mellon (BK, $38.48) is now offering custody services for crypto.

Ukraine War:  Russia continues its attacks on civilian infrastructure in Ukraine.

• For the second day, Russia is hitting infrastructure targets in Ukraine. As these attacks continue, NATO is mulling over whether it should provide more sophisticated air defense systems to Ukraine.  If these are provided, it will be part of a steady broadening of the war effort.
  • Sanctions on technology appear to be undermining Russia’s ability to build smart weapons. The lack of precision weaponry is leading Russia to rely on less sophisticated weapons, which is leading to indiscriminate damage.
• As the war continues to go badly for Russia, Putin has appointed another general to lead the effort. Sergei Surovikin is considered a hardline professional soldier who conducted the Syrian campaign.  It remains to be seen if he can fix the Russian military’s problems in Ukraine.
• Putin and Turkish President Erdoğan met in Kazakhstan today. Turkey has supported both sides in the Ukraine war, and so Erdoğan has suggested he could act as a broker between the two sides.

China News:  The news is quiet in front of next week’s Party Congress.

• As the Party Congress prepares to meet next week, the party is increasing security to ensure a smooth “coronation” for General Secretary Xi.
• Chinese universities are rising in world rankings, while U.S. universities retreat.
• Utah is becoming a virtual marriage destination for Chinese LGBTQ couples.

 International Roundup:  Japan reviews its defense posture.

• Japan’s PM Kishida is preparing for an extensive review of Japan’s security. Since the end of WWII, Japan has relied on the U.S. for security, but facing a more uncertain future, it appears that Tokyo is moving to expand its power projection.
• We are covering the tensions between Saudi Arabia and the U.S. in our Weekly Energy Update, which will be published Friday.

[1] A Dutch economist who was the first to win a Nobel prize.

[2] When the Fed faced this issue in 1929, it opted to address the inflation/asset bubble instead.

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