UK – Emerging cracks
The UK continued to experience market turbulence last week following the announcement of the “mini-budget”. The sell-off in UK government bonds triggered strong market instability, forcing the BOE to intervene in the market via a two-week purchase program of long-dated bonds. The gilt sales program was delayed until the end of October, as a result.
The decision by the Financial Policy Committee came as pension funds started receiving margin calls on their Liability Driven Investment strategies (LDIs), forcing them to sell their most liquid holdings (long term gilts) in order to meet collateral requirements, ultimately creating the potential of a downward price spiral, and de facto a run on the funds.
This announcement caused a massive drop on 30-year gilts yields, about 1.1% just on Wednesday. The yield on 30-year UK gilt is now 3.8%, from just above 5% before the announcement on Wednesday.
Overall, we believe the UK has moved towards a fiscal expansion at the wrong economic juncture, as high inflation reduces budget space and post Brexit the overall macro credibility has reduced. We thus think the market will continue to test authorities, and UK assets will remain under pressure until the BOE delivers a bolder hike or the government comes out with a credible plan to restore the fiscal trajectory post 2022/23 expansion.

Fixed income – One step closer to capitulation
Following last week’s turmoil in UK, global fixed income markets look one step closer to capitulation. Stress in UK led to a deep selloff in global fixed income markets, both in rates and credit. 10y US Treasuries crossed 4% on Tuesday, and weekly outflows in all credit markets have been the largest of the year. The BOE announcement led to a broad stabilization, despite the very nature of the intervention. The market read-across is clearly that central banks can’t be insensitive to market volatility, and the Fed will soon follow the BOE in calming markets. We think this is not entirely correct. It is true that central banks are following the situation closely, but US markets are far from malfunctioning, giving little reason to the Fed to move immediately. The central bank can thus wait for the October and November inflation prints (which will show a clearer drop) before sounding more accommodative.
However, rates markets now price almost 5% terminal rate for the Fed and more than 3% for Europe. Credit spreads imply unusually high default rates. Short rates and long USD positions are at all-time highs, and outflows from credit funds have never been so high. Fixed income markets look one step closer to capitulation, and a mild signal from the Fed could at this point provoke a quite strong tightening of financial conditions in rates, credit, and FX.

Ukraine war – Further escalation
The Ukraine war approaches a new phase of escalation. Last week, separatist regions in Eastern Ukraine held a referendum for annexation to Russia. The result was a landslide victory of the pro-Russia camp, and Putin announced formal annexation of the regions just ahead of the weekend. The Ukraine government, together with all Western governments, does not recognize the new border. In fact, Ukraine troops have stepped up fights in the Donetsk region over the weekend. In other words, Putin attempt to formalize territorial gains have been strongly rejected by the Ukrainians, so the war has taken a further escalation leg. Chances of another round of negotiation (which looked higher over the past month) are now close to zero, and the conflict will last longer. The fact that Russia will now consider the conflict to be partially taking place on its territory also open tail risk.
The escalation continues in parallel on the energy front. Multiple faults have affected NordStream pipes over the past week, and Gazprom stopped sending gas to Italy over the weekend. Tension from the East is set up to remain higher for longer.

Eurozone inflation – At highs, but no change in ECB picture
Headline inflation in the Eurozone climbed to 10% year-over-year in September, from 9.1% in August. The core rate rose by 0.5pp to 4.8%.
The headline number was driven mainly by a further rise in energy inflation, to 40.8% year-over-year after 38.6%, reversing falls in recent months. In the core, services inflation jumped by 0.5pp, to 4.3%, mainly driven by an upside surprise in Germany given due to the temporarily reduced rail fares. Non-energy goods inflation edged higher by 0.5pp, to 5.6%.
In Europe, we believe that the peak in inflation is not as close as it is in the US. Headline inflation is still very dependent on the unpredictable energy crisis. Whilst core inflation might be closer to the peak, it will be very sticky. Following this data, our view of a 75bps rate hike at the next ECB meeting is reinforced.

Algebris Investments’ Global Credit Team