UK’s inflation beating energy plan and the ECB shows its metal

The big news this Thursday is that Queen Elizabeth is said to be gravely ill, the centre piece of Liz Truss’s first days as prime minister – her energy plan – has been replaced in the media by wall-to-wall coverage of the Monarchy. Depending on the outcome, the media coverage could stay focussed on the Monarchy for some time after the announcement from Buckingham Palace earlier today. While our thoughts are with the Queen, we shall continue with our analysis of some other epoch-shifting events for financial markets that happened today. The UK’s energy plan was announced, and the ECB bit the bullet and raised interest rates by 75bp.

Truss saves the day, or does she?

The UK’s energy plan had been well-signalled in advance and was announced earlier on Thursday by the new Prime Minister. Average household energy bills will be capped at £2,500 per year for the next year, until the next general election. The current energy price cap of £1,971 will be maintained once the £400 universal handout is added to the package of support.

This package is less generous for businesses than had been expected, with a six-month cap on business energy bills, however the government said that this may be reviewed and extended for vulnerable sectors. The government did not produce a final cost for the scheme; however, it is expected to cost in the region of £150bn. The government announced an end to the ban on fracking and plans for 100 new oil and gas drilling licences in the North Sea. The government is also setting up an energy task force to negotiate with domestic and international suppliers to agree long term gas contracts. It is also going to negotiate with renewable suppliers of electricity, which are not on fixed price contracts, to try and the lower the price of energy in the UK from all sources.

The impact on inflation

The markets are interested in how this will impact the UK’s inflation and growth forecasts and shift the dial when it comes to the UK’s economic outlook. On the inflation front, it’s worth noting that bills could still rise next year for households, as the energy bill cap and the £400 universal support is still approx. £150 below average energy costs. However, this is a significant improvement than the £5,000+ annual energy bills that were touted a few weeks ago.

It will be interesting to see how the ONS treats this package of support, and whether it will impact future inflation figures. Last week, the ONS said the universal household handout of £400 was considered a current transfer to households, thus it would have no impact on inflation. It said that the transfer would increase household income, rather than reduce household expenditure.

By capping energy prices, this latest package of support will reduce household expenditure significantly, which should reduce inflation forecasts.  There is a question over whether the ONS will treat it slightly differently because the taxpayer is picking up the bill, but one must assume that at some stage taxes will rise to cover this cost, thus, we think that the ONS will classify this latest package as reducing household expenditure, and it will have a downward impact on inflation.

UK inflation to peak earlier than expected

In terms of the impact on inflation, Barclays is saying that inflation may have already peaked at 10.1% in July, whereas a cap of £2,000 would see CPI inflation peaking at 10.4% in October. The latest BOE forecast, is for UK CPI to peak at 13.3% in Q4 22. It could also make obsolete last week’s predictions from Citi and Goldman for UK inflation to reach 18% and 22% respectively.

If this is formally announced in the coming days then it’s good news for UK inflation forecasts and the growth outlook, and we would expect to see an uplift in UK growth forecasts for 2022 and 2023 in the coming weeks.

The market impact

In terms of the market impact, European and US stock markets is a sea of red right now, and energy companies have been hit as the UK government announced a plan to bring down the long-term costs of gas and electricity in the UK, even though they stopped short of announcing windfall taxes on energy companies. GBP/USD had staged a mini recovery earlier today, however, a mixture of news about the Queen, a strong dollar, and the potential for the energy support package to play havoc with the UK’s long term fiscal outlook, is weighing on the pound, which fell to a fresh low of $1.1470 earlier on Thursday, although it has managed to bounce slightly from there. The bond market had been hit hard, with UK bond yields surging this week. However, Thursday’s increase of 10 basis points, is not unique to the UK. After the ECB raised interest rates, the German 10-year yield rose by a similar amount. Overall, we think that bond yields will remain under pressure for some time.

The ECB hikes rates but keeps the liquidity flowing

Elsewhere, the ECB delivered a 75basis point rate hike on Thursday, for only the second time in its history. It is following the US in mega rate cuts and is firmly in the camp of stamping out inflation. However, there are a couple of issues we have with today’s ECB meeting. Firstly, their growth projections seem ridiculous, and it is hard to see how the market will take them seriously: growth is expected to rise by 3.1% in 2022 and 0.9% in 2023, so the ECB is expecting the Eurozone to avoid a recession. We think this is unlikely, as German economy’s fortunes are closely linked to Russian gas and energy prices, so these forecasts seem, to be in la la land. The ECB press conference was important. The ECB also announced that it would keep excess liquidity higher for longer and they will pay billions to the European banking system within that excess liquidity, as interest rates have just risen by 75bps. Thus, the ECB is simultaneously hiking interest rates at the same time as it is pumping the Eurozone financial system with money. Therefore Italian 10-year bond yields have only risen by 8 basis points today, although they remain uncomfortably close to 4% for the ECB, in our view. The euro is also in focus, and EUR/USD is down 0.5%. Partly this is because of the all-powerful dollar, but it is also down to the fact that the ECB is keeping excess liquidity higher for longer. This is not going to be pretty for the Eurozone or the ECB, but it is good news for Europe’s banks. Commerzbank is up 4% today, Société General is up nearly 2% and Deutche Bank is higher by 4.1%.