BNY Mellon

Entrusting Truss With Gilts

New Prime Minister Liz Truss isexpected to announce a major support package for UK households within days, ifnot sooner. As highlighted last week, the prospect of energy bills moving frombarely 3% of median household disposable income to closer to 20% is likely tohave devastating socio-economic consequences. As EU governments are expected toswiftly announce their own measures, it has become clear that windfall taxeswill need to be part of the solution, as will be the case in Germany.

However, Truss had beenprioritising tax cuts to kickstart growth throughout her leadership campaign,so it will be hard for her not to deliver revenue-based easing. This setsthe UK up for some serious questions on fiscal credibility – it is alreadybeing tested in bond markets. We share concerns regarding the right balance offiscal plans in the UK and expect some degree of fiscal risk premia to featurein the near term. However, we think fears of unfunded tax cuts and energysubsidies precipitating a fiscal collapse are not justified.

Some details of tax cuts havealready been floated in the media; they appear to be heavily skewed towardsreducing the burden of work-related income to free up space for more spending.Initial proposals reportedly include reversing the rise in National Insurancelaunched earlier this year by former Chancellor and the runner-up in theleadership race, Rishi Sunak. While the improvement in household cashflow wouldbe beneficial to a UK economy still highly dependent on consumption, there willlikely be immediate concerns over a sharp drop in revenue. As the chart belowshows, National Insurance and Income Tax together contribute close to £400bn tothe exchequer, almost six times the level of corporate taxes, which were raisedthis year as well. In addition, there are also appear to be proposals to reducevalue-added tax, though it remains to be seen whether this is done on energy orenergy-related items, which is already being applied across Europe.

ING

USD: Equities Divergence Matters

US markets re-open after a long weekend today and futures currently point at a slightly positive open in the Dow Jones, despite yesterday’s slump in European equities. Diverging US-European equity performance is becoming a relevant theme for FX as a driver of USD strength: in our EUR/USD short-term fair value model, the relative equity performance factor has seen its beta grow steadily since the start of July. Indeed, the ongoing energy crisis does suggest that it will take time to restore trust in European assets. In the past three months, the Dow and S&P500 are both down -5%, while the DAX has lost 13% and Euro Stoxx 9%.

Expect a pick-up in volatility today after yesterday’s rather muted trading. On the data side, markets will focus on the US ISM Service index, which is expected to have dropped after July’s modest rebound. This is probably the most important piece of data before the CPI report on 13 September, and with markets still torn about the possibility of a 75bp Fed hike in two weeks (65bp is priced in), asset classes should prove quite sensitive to the release.

There are no scheduled Fed speakers today, but we’ll hear from a plethora of members tomorrow and from Fed Chair Jerome Powell on Thursday.

Barring a major dovish repricing in Fed rate expectations, the strong dollar story should remain broadly untouched this week, as the energy supply crisis keeps markets away from most European currencies and may fuel safe-haven flows further. As we’ve highlighted in recent notes, the yen’s role as a safe haven has been eroded by Japan’s worsening trade position, and the USD/JPY rally may have further to go until Japanese authorities intervene.