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Analysis: Market chaos awaits new UK leader

Analysis: Market chaos awaits new UK leader

Conservative leadership candidate Rishi Sunak waves as he stands next to co-candidate Liz Truss during a husting event, as part of the Conservative Party leadership campaign, in London, in Great Britain, August 31, 2022. REUTERS / Hannah McKay

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  • Truss is set to become prime minister on Monday, polls show
  • She has made tax cuts a centerpiece of her political plans
  • Direct aid for the cost of living is also promised
  • Fiscal worries add to problems for UK bonds and the pound
  • Talk of rethinking the BoE’s mandate is another uncertainty

LONDON, Sept 2 (Reuters) – Liz Truss, set to become Britain’s prime minister on Monday, looks set to head straight into a storm in financial markets that she will need to act quickly to extinguish.

The pound had its worst month against the dollar in August since shortly after the Brexit referendum in 2016 and also fell against the euro. Some UK government bonds have suffered their biggest price falls in decades. Much of the market turmoil is due to a runaway inflation rate which is the highest among the Group of Seven economies. Goldman Sachs says it could hit 22% if the impact of the Russian invasion of Ukraine on gas prices does not fade.

Many investors are also worried that the tax cuts promised by Truss could make Britain’s inflation problem worse, accelerating interest rate hikes by the Bank of England and deepening a recession the BoE expects to end. start this year and not end until 2024.

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In addition to tax cuts, Truss recently pledged “robust” direct cost-of-living support for households, which would further weigh on the budget deficit.

Then there are his plans to rethink the way the BoE does its job and be prepared to risk a post-Brexit trade war with the European Union.

“I think the UK and the gilt market are in danger,” said Mike Riddell, senior fixed income portfolio manager at Allianz Global Investors in London.

He pointed to the sharp falls in recent weeks in the prices of British government bonds, or gilts, and the value of the pound sterling, a rare occurrence.

Normally, the prospect of a BoE interest rate hike would hurt demand for bonds while pushing the pound higher, but the currency is down 15% against the US dollar since the start of the month. year.

Until August, there had never been a month when the pound fell 4.5% against the dollar and 10-year gilt yields rose more than 90 basis points, the data showed. of Refinitiv and the Bank of England dating back to 1971 when the pound was floating. .

“The breakdown in the relationship between gilt yields and the pound indicates that overseas investors are losing confidence in the UK, and that’s what’s really worrying,” Riddell said.

BREAK THE ORTHODOXY

Opinion polls have given Truss – currently Britain’s foreign secretary – a big lead over Rishi Sunak, who resigned as finance minister in July to contest the Conservative Party leadership race which ends on Monday with the announcement of the winner.

As a former chief secretary to the Treasury, Truss says she knows how to shake up economic orthodoxy by reducing Britain’s tax burden which is heading for a 70-year high.

Sunak dismissed his tax cut plans as “fairy tales” that will fuel inflation.

Asset management firm Pictet said this week it was underweight gilts due to the risk of a strong stimulus that could force the BoE to step up its rate hikes.

Julian Jessop, an economist who supports Truss and is close to his advisers, said the idea of ​​borrowing more now to accelerate future economic growth made sense.

“In these circumstances you need to be bold and flexible on fiscal policy and if that means in the short term the budget deficit needs to be strained, then so be it,” he said. .

UK public finances are weighed down by the government’s huge coronavirus spending spree.

Public debt as a percentage of economic output is not far from 100%, compared to around 80% before the pandemic.

But Jessop, a member of the Institute of Economic Affairs think tank, said Truss was likely considering additional borrowing of tens of billions of pounds, far less than during the COVID-19 pandemic, which financial markets could swallow.

“Once she gets the keys to number 10 (Downing Street) she can start reassuring the markets about what she really intends to do,” he said.

THE KINDNESS OF STRANGERS

For some investors, that kind of clarification can’t come too soon, with Riddell noting that a planned sale of a big slug of 30-year gilts in mid-September will be a test for Britain’s debt office.

Oliver Blackbourn, UK portfolio manager at Janus Henderson Investors, said there were also political risks for Truss, who is set to become Britain’s fourth prime minister in six years.

She trailed other candidates for much of the Conservative Party leadership race when she was in the hands of party lawmakers, climbing to second place at the last minute to contest the run-off, which is decided by party members.

“How easy will it be for her to control her party in the House of Commons when she was nowhere near the most popular choice among MPs? said Blackbourn.

“When you have tough decisions to make, you want to have a strong leader in place.”

For Jessop, the economist who backs Truss, the first item on the agenda if she is announced as prime minister on Monday should be a promise not to meddle in BoE independence.

Truss said he wants to review the central bank’s mandate without compromising its independence, but one of his supporters questioned whether the BoE should have exclusive power to set interest rates.

“It’s very important that she gets going with a clear policy statement,” Jessop said.

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Additional reporting by Andy Bruce and Humza Jilani Writing by William Schomberg Editing by Philippa Fletcher

Our standards: The Thomson Reuters Trust Principles.

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