Post-Truss Stress Disorder

By Stefan Koopman, Senior macro strategist at Rabobank

Imagine securing a record-breaking majority, meticulously briefing every major policy shift you want to make, doing everything economists and central bankers had once begged you to do, start thinking about spending and investment in a strategic way, pre-announcing key decisions well in advance – only to emerge as a knockoff of Liz Truss.

As we outlined in our post-Budget special, there’s a straightforward diagnostic for assessing how fiscal announcements impact bond yields and exchange rates. An uptick in yields alongside a steady currency is not a ‘spooked’ market: it’s exactly what you’d expect – and what you’d want? – from fiscal loosening. And while it’s tempting to compare a yield with Germany’s, please keep in mind here that Germany and its ultra-low bund yields are NOT the benchmark for sound fiscal policy – it’s the benchmark of fiscal masochism that damages a country long-term.

So while we initially thought the Reeves’ budget might be faring better than Truss’s with the market, yesterday’s market reaction proved otherwise. Gilt yields rose sharply across the curve, more than in other G10 economies, and the currency depreciated instead of appreciated. It seems the UK bond market is still caught in a case of “post-Truss stress disorder”. The second it’s faced with a bit of uncertainty and unfamiliar territory, investors are playing it safe: de-risk first, ask questions later. Fair enough – it’s still small beer compared to what we’ve seen in 2022, but when the correlation between yields and currency flips, it’s a red flag.

That being said, we think the sell-off is overdone. Yes, the Budget implies some fiscal loosening, but only if you compare it to the Office for Budget Responsibility’s March projections. Those projections were crafted by a government that knew it was on its way out. The unrealistically deep spending cuts, reminiscent of Osborne’s severe austerity measures, were never going to fly, but do complicate the current fiscal narrative. Consider this: the OBR forecasts that the current deficit – defined as the gap between day-to-day spending (excluding capital investment) and current revenues – will shrink from £55.5bn this year to a surplus of £10.9bn in four years. Furthermore, the £100bn increase in capital spending over the parliamentary term is merely to maintain a stable ratio of public investment to GDP. Isn’t this precisely what policymakers and economists have been advocating for?

The risk of stickier inflation is not necessarily a UK problem. My colleague Elwin de Groot notes that Eurozone inflation figures yesterday confirmed what data from several member states had already flagged the other day: that core and services inflation remain relatively sticky and that food and energy inflation were the key contributors to the rebound in headline inflation to 2% y/y in October from 1.7% in September.

Some of that rebound had been expected due to a less favorable base comparison. However, food prices did rise significantly more sharply than expected (more than 7% m/m on a seasonally-adjusted annualised basis). If this does not reverse in the next month, it could be a sign that businesses have resumed the passing-on of cost increases to consumers. This would also be consistent with a pick-up in consumer spending, a hint of which we received Wednesday with the unexpected Eurozone growth pickup in Q3.

However, it is too early draw any strong conclusions yet. The key message from yesterday’s Eurozone HICP report was above all that core inflation and in particular services sector inflation remain persistent albeit gradually losing pace. Services inflation stayed put at 3.9% y/y – which has basically been the average rate since November 2023. On an annualised basis, seasonally adjusted prices rose some 3.8% m/m. As long as the economy doesn’t fall off a cliff and growth of negotiated wages remains in the range of some 3-4% (which in a relatively tight labor market usually translates to even slightly higher growth of employee compensation), services inflation is likely to remain on a path of gentle decline.

In the past two days, the market has pared back its ECB rate cut pricing for December, although it is still pricing for some 20% chance of a 50bp cut rather than a 25bp one. Since the comment made in the October ECB meeting that “everything pointed in the right direction” [for inflation], the actual October inflation data may serve as a reality check. We maintain our view of a 25bp cut in December.

In the US, PCE inflation slowed to 2.1% year-on-year in September, marking the lowest annual rate since February 2021. Core PCE inflation, however, remained steady at 2.7% for the third consecutive month, printing on the high side with a 0.254% monthly increase. Personal spending rose by 0.5%, driven not only by income growth but also by a decline in the personal saving rate, which fell to 4.6% in September. As the labor market shows signs of cooling – with fewer job openings, slower hiring, and a decrease in voluntary quits – the sustainability of this trend of under-saving is in question.

This cooler market is also exhibiting fewer inflationary pressures. The Q3 Employment Cost Index data revealed that private sector wages and salaries grew at an annualized rate of 3.1%. With a target inflation rate of 2% and trend productivity growth somewhere between 1% and 2%, wage growth at 3.1% is not inflationary and could easily justify a ‘normal’ 25 basis point cut by the Federal Reserve next week.