Sterling tries to rally as Truss faces economic whack-a-mole

Liz Truss has been named the next PM – with the cost of living crisis, fiscal and energy plans are the priority. Sterling came off the lows but mooted fiscal largesse could pose inflation risks and Deutsche Bank is out with an interesting if slightly over-the-top note warning on the UK’s ballooning current account deficit leading to a risk of a sudden stop a la emerging markets. The fear is that Truss makes policy mistakes that deepen the UK’s economic problems, and this leads to further sterling weakness. GBPUSD approached the 1.1440 area, a level it last traded only briefly in 2020 at the peak of the pandemic sell-off and perilously close to levels last traded in the mid-eighties, before mounting a fightback to 1.16 this morning. Gilt yields also pulled back after earlier spiking, perhaps a sign that a lot of the bad news for the UK economy, inflation and Trussonomics is priced?

And what are we talking about here? It’s kind of trickle-down, watered-down Reaganomics (the state is today is huge and she doesn’t have the freedom to cut it back like he did) – lower taxes designed to boost business investment and consumer spending. She talked about a “bold plan to cut taxes”, which might not help the inflation fight much if it’s not terribly targeted. Plans to look again at the Bank of England’s mandate have clearly unsettled some and left the pound with another headwind. Uncertainty over the NI Protocol being another, sterling has clearly got lots weighing it down and making it particularly unloved.

 DB: “With the current account at risk of posting an almost 10% deficit, a sudden stop is no longer a negligible tail risk. The UK is increasingly at risk of no longer attracting enough foreign capital to fund the external balance. If so, sterling would need to depreciate materially to close the gap in the external accounts. In other words, a currency crisis typically seen in EM.”

More DB: “A very large but untargeted spending package — such as a 10ppt VAT cut — would risk materially worsening the already wide current account deficit and exacerbating investors’ fears about its sustainability — quite apart from worries about fiscal sustainability.”

DB’s note is not short on hyperbole, but really…? Certainly, there are risks that the new PM is a bit fast and loose with fiscal policy, which could widen the deficit further, but a “sudden stop” they are talking about in the note seems altogether unlikely. But it’s certainly true to cast the UK as the least-well-positioned major economy post Covid; and inflation is ripping here more than just about anywhere else. Let’s see what Truss has to offer – sterling might have further to travel yet if the worst is yet to come. But should the market’s deepest fears about ‘irresponsible’ fiscal policy prove to be unfounded, we might just have seen the bottom in for sterling.  The truth is there so much uncertainty and so many risks and challenges facing the new PM we simply don’t know what’s coming; a kind of economic whack-a-mole.

One thing that could help protect sterling from further losses would be a central bank with a stiffer backbone. So far it’s taken a rather supine and ‘gradualist’ approach which has failed to contain inflation or rein in inflation expectations. Rate setter Catherine Mann, a relative hawk on the Monetary Policy Committee, says it has not worked and called for “fast and forceful monetary tightening”. Is the rest of the MPC listening? Last month the Bank of England said it would “act forcefully”. Markets see a roughly 85% chance of a 75bps hike next week.

On energy prices – vital for household spending and avoiding a deeper recession – Truss is reportedly working on a plan to freeze bills at a level the current rate, and avoiding the whopping increase due to kick in next month. Capping energy prices – albeit kicking the can down the road again – would certainly help rein in inflation expectations and help shove the genie back in the bottle.

GBPUSD continued its gains this morning to move to 1.16 before pulling back a whisker. Resistance is not close (maybe look to 1.1720 area) so this relief rally may enjoy further strength due to seller exhaustion and profit taking. Relative dollar strength is not restrained to cable, with USDJPY up to 141.50 today. Remember the Fed’s QT doubles this month – liquidity is evaporating just as rates are rising and markets fret about recession. Not a happy cocktail for risk assets, and one that is expected to support continued dollar strength. Betting against the dollar this year has been a mug’s game.

Elsewhere, stock markets in Europe firmed this morning after losses on Monday, albeit the FTSE 100 eked out a small gain against the trend as oil rose. Wall Street returns after the Labor Day holiday with stock futures higher. China did some more easing by cutting its FX reserve requirement. The Reserve Bank of Australia raised rates by 50bps as expected. US 10yr Treasury yields sit above 3.26%.

OPEC trimmed production by 100k bpd. Many seemed surprised by this but the language from the Saudis was, I thought, reasonably clear ahead of the meeting. Last month OPEC and allies agreed to increase production by 100k bpd, so the move reverses this tiny increase…not much success for Joe Biden from his meeting the other month, then. The next meeting is slated for Oct 5th. Crude prices rallied, with WTI futures nudging up to the $90 mark and Brent above $96, before paring gains somewhat.