am/FX: A Matter of Truss 18AUG22

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Today, a slightly longer piece (4 pages, 7-minute read) looking at how Liz Truss may or may not impact GBP as the new PM of the UK.

by Brent Donnelly

August 18, 2022

This is not the stamp in question,

it’s just a cool stamp from Korea.

When was the first

postage stamp issued?

Current Views

Short ES1 @ 4272

Stop loss 4366

Take profit 4010

A Matter of Truss

On September 5, the United Kingdom will have a new Prime Minister and her name will probably be Mary Elizabeth (Liz) Truss. Current gambling odds place her as a 1:8 favorite, and the movement of the odds since July looks like this:

The Party member ballot will close at 5pm on Friday 02SEP. The winner will be announced on 05SEP. That winner will become Leader of the Conservative Party and the next Prime Minister.

With a Truss win a somewhat foregone conclusion, it’s worth knowing what she might mean for the future of the UK economy, gilts, and the pound. First a few facts to set the table. As I chatted with UK peers and colleagues, I learned that the Liz Truss topic is a highly charged political discussion, even when you are just hoping to talk about the economics. I don’t have a political view here; I’m just trying to figure out whether to be long or short pounds.

Truss is a bit hard to pin down because:

She is not rigidly committed to a single worldview. Whether this makes her a flipflopper or a Bayesian pragmatist depends on your politics, I guess. She was a Liberal Democrat until 1996 and is now a Conservative. Her Brexit stance into the vote was “Remain” but since 2017 she has been pro-Brexit. Her explanation: “I believed there would be massive economic problems but those haven’t come to pass, and I’ve also seen the opportunities. I was wrong and I am prepared to admit I was wrong. Some of the portents of doom didn’t happen and instead we have actually unleashed new opportunities after Brexit.”
She idolizes Thatcher but then proposes a variety of policies that are not fully consistent with Thatcherism.
She espouses aggressive fiscal spending and a sort of ‘move fast and break things” approach but much of her support comes from fiscal conservatives.
Candidates say many things and make many promises but those don’t always come to pass in real life. The candidate and the elected official are often two different people with different incentives and objectives. It’s never safe to just take a candidate’s word on policy and assume it’ll play out. Some of Truss’ debate comments sound pretty random and off-the-cuff.

Some key things to know re Truss:

She wants to spend more money. She has a plan for an emergency budget to reverse the national insurance rise, scrap the planned corporation tax increase, cut personal taxes, and suspend green levies on energy bills.
Her fiscal plans could boost GDP by 0.5% or so and corporate earnings by up to 6%.
She wants to project an image of “business friendly”.
She’s not too worried about deficits. She wants to rejig the COVID debt accounting to help make room for the new fiscal moves.
She has mentioned monetary targeting a la 1980s as a possible option for monetary policy.
She has discussed changing the Bank of England’s remit. Here’s a quick excerpt from a Bloomberg article:

Foreign Secretary Liz Truss, the front-runner to succeed Boris Johnson as prime minister, has said the UK is facing an unprecedented economic situation and that the “business as usual economic strategy” isn’t working. The BOE should remain independent, but the time has come to revisit its mandate, she said. In a newspaper article, Truss said the recent commodity-induced inflation spike has been “exacerbated by monetary policy.” How she would revise the current system is unclear. She hasn’t said she would scrap inflation targeting but did mention the possibility of widening the target to include a measure of money supply or nominal gross domestic product.

The consensus view is that these policy proposals are bearish for gilts and bearish for GBP. This quote is a good summary of the consensus view:

“Truss’s policy platform poses the greatest risk from an economic perspective in our view with an unseemly combination of pro-cyclical tax cuts and institutional disruption,” Citi’s chief UK economist, Ben Nabarro, wrote in a note.

The argument is that more fiscal spending will swell deficits while any review of the BOE’s remit is bad for institutional stability and could reduce BOE independence and lead to a flight from UK assets. This makes sense on the surface, but there are some pretty good counterarguments.

Fiscal spending could help the UK economy at the margin. Given armageddonish expectations for the UK economy, a change of tactics is unlikely to make things worse than expected but could potentially change the angle of descent. Very hard to imagine Truss making things worse in the short-term.
When the Democrats in the USA swept to a Blue Wave and all sorts of fiscal stimulus was coming, the market sold USD and sold bonds, using the same logic that applies to the current thinking on the UK. Twin deficits will balloon and such. That trade was wrong and the combination of loose fiscal and tight monetary policy in the US has triggered a massive dollar rally. The last time I can remember the “deficits will lead to capital flight” framework being useful was the Canadian debt panic in the 1990s. In an MMT world, investors don’t care about deficits.
I highly doubt the BOE remit thing is going to happen. My guess is that once she is in power, that idea will just quietly be dropped. Her line of thinking is totally nonsensical on this topic and my guess is that she will reconsider once the thought process is probed further. Here are a few snippets on this:

From a Liz Truss editorial in the Telegraph

Headline: I will pave the way to economic growth with an emergency budget

So, imagine her looking around the world. “Hmmm, inflation is really high everywhere. Except Japan. They must be doing something right!” You might think I’m joking. But check this out:

She said the next government should look at other economies that had been successful in controlling inflation, citing the Bank of Japan which has faced repeated bouts of deflation in recent decades despite running the biggest quantitative easing program of all major central banks.

This sounds like something out of The Onion. And she was once UK Treasury Secretary. Amazing. She is worried about high inflation and nodding to BOJ policy as a solution. C’mon. Anyway, given her views about the BoE are poorly informed and make zero sense, my guess is that they will be reprogrammed. Especially because she comes across as pragmatic / flexible, not super dogmatic. If she is open to new information, the new information will be something like:

Advisor

“But Ms. Truss, the Bank of Japan is the loosest central bank in the world. It owns more government debt than the BOE and is the largest equity shareholder in Japan. Their balance sheet is 135% of GDP and ours is 40%. They have been pegging rates at zero for eons. If we did that here, CPI would be 25%.”

Liz Truss

“Oh. Ok, forget it.”

When Truss enters office in September, she will need to prioritize a massive list of risks and issues. I just don’t think the BOE remit will be on that list. Or if it is, it will be a watered-down, long-term word salad kind of thing where nothing ever comes of it. Regardless, when I think about the changes in the central bank remits around the world… NZ added housing, USA went to average inflation targeting… Was any of it actionable? Not really. Maybe for two months or something. Global central banks are all fighting the same war with similar weapons.

Down the road, a scenario where Truss attempts to defang the BOE as they outhike the momentum of her inflationary fiscal plans could be a possibility, but I think that’s something to worry about later. Or never.

There is a bullish GBP scenario where the Bank of England tries to offset looser fiscal by tightening monetary and the GBP rips as positioning is mega short, sentiment could not be more bearish, and yield direction still drives currencies most of the time. The problem with trying to trade this bullish scenario right now is:

Even if the bullish scenario is correct, GBP could sell off first as many in the market believe Truss is bad for GBP, not good.
The energy crisis is way bigger than the views held by the occupant of 10 Downing. Winter is coming.
USD is king these days so long GBPUSD is very difficult, regardless of what happens in the UK.
A lot is priced into UK rates already and real wages are cratering. Moar hikes is a big ask.

At the risk of getting overly complicated, I think there is a good chance that there is a kneejerk GBP selloff into and after a Truss victory, but it’s short-lived and GBP then finds a base and rips higher, especially against the EUR. If you’re gonna trade long GBP, I think short EURGBP is the ticket because it mostly strips out the energy crisis as the EU suffers from the same energy woes as the UK.

Perhaps short gilts is just the easier trade and the currency is too complicated, but the “down a bit then up a lot” trade in GBP seems highly likely to me. Far down the road, deficits might matter or the BOE might outhike the fiscal and drive the UK economy further into the ground, but the takeaway here is:

I don’t think selling GBP on a Truss victory is a good idea. To summarize:

First order impact: More fiscal. Sell gilts, buy GBP.

Second order impact: BOE remit review. Sell gilts, sell GBP if it happens?

Third order impact: Bigger deficits, more credit risk. Sell gilts, sell GBP.

It almost looks like the market is trying to do the “sell UK fixed income + sell GBP trade” in recent days as EURGBP rallies while gilts sag. You can see that here: