21 October 2022: Sunak favourite to replace Truss

Sunak favourite to replace Truss

21st October: Highlights

  • Truss’ resignation adds to political turmoil
  • Fed accused of reckless tightening of monetary policy
  • Eurozone current account deficit widens to €26.8 bn

GBP – New Prime Minister to be elected by 28th October

Rishi Sunak, who was defeated by Liz Truss in the ballot to be Conservative Party leader, is the hot favourite to replace her following her resignation yesterday.

Truss became the shortest-lived Prime Minister in history, lasting just 44 days. It is hard to understand how Conservative MPs could have got it so wrong. They elected someone patently out of their depth to lead them into the next General Election.

The rules of the ballot to elect a replacement were announced yesterday. Any candidate wishing to stand must garner the support of 100 MPs by this Monday. Voting will take place next week and the result will be announced a week from today.

There is a rumour that Boris Johnson will throw his hat in the ring, but that would be a retrograde step despite the former Prime Minister’s record of wooing voters.

The past 44 days have seemed like something from the pages of a fantasy, as Liz Truss brought in the most diverse Cabinet ever to deal with an issue that didn’t really exist. Her plans to grow the economy out of the current downturn by using a policy of trickle-down economics was doomed to fail.

To carry the country with you, in the manner of Margaret Thatcher, by sheer force of personality, one must have a personality in the first place. Something that was sadly lacking in Truss.

Early opinions consider Rishi Sunak to be a safe pair of hands as far as the economy is concerned, making considered judgements on the issues that Truss was unable to master.

His record in other areas of political life outside finance and the economy is sketchy at best, although several senior Tories have gone on record, saying that he understands the need to be surrounded by expert advisors.

Some hope Sunak will be the only candidate making the ballot more of a coronation. But it’s also clear that Sunak is not universally liked. However, the next-best candidate, Penny Morduant, may be considered too much of a risk given her similarities to Truss.

The financial markets were in a reflective, rather than celebratory, mood yesterday. They appreciate that the new Prime Minister faces several tough decisions on taxation, the economy and the fight against rising inflation.

Sterling was marginally stronger on the day, reaching a high of 1.1336 and closing at 1.1229.

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USD – The Central Bank’s proof will be in the pudding

It is common for economists who study the actions of the central bank to make daring and sometimes outlandish claims. In the rare event they come true, they consider themselves some kind of market guru.

That is, until said prophecies are revealed to be little more than a fluke or guesswork, and they crash back to earth like a spent firework.

That is the scenario facing members of the FOMC, who are being second guessed, not only regarding their possible actions on November 2nd, but also regarding the likely effect of those actions on inflation and the economy.

We all are party to the same economic data, and it is the understanding of which numbers are considered most significant to the Central Bank that is the jumping off point.

For example, when it comes to inflation, the Fed favours Personal Consumption Expenditures as an indicator since it is a broader measure, while the markets prefer headline Consumer Price Index which is more easily understood by the public.

By far, the broadest indicator of the performance of the economy is the strength or otherwise of the currency.

However, that is not always the case, as has been seen recently in the turmoil that Sterling’s gyrations. Traders have moved on though and they now use the dollar index as using a mix of several currencies, even if those have become less influential, is considered to provide a more efficient measure.

In the run-up to the Fed meeting in a couple of weeks’ time, there will be several theories considered about the size of the hike and its effect on the wider economy.

Since none of the members of the FOMC will confirm their intentions in advance, this leads to the speculation described above.

All we know for certain is what Jerome Powell has already confirmed, and that is that the Central Bank will continue to raise interest rates until it is satisfied that it has achieved price stability without damaging growth.

The market is content to speculate that the October employment report will be an acid test for the Fed’s intentions, but all that has been said officially is that the Central Bank is data driven and reactive.

Yesterday, the Dollar Index reflected the market’s uncertainty. It closed a little lower on the day at 112.90 having fallen to a low of 111.86.

EUR – Recession risk and high inflation threaten stability

The European Union is still a work in progress. No one can expect to build a completely new state out of nineteen vastly different economies in as short a period as twenty years and have every crease ironed out.

Progress has been made over the social charter and work is now mostly complete.

However, there is a considerable amount of work to do on the economy, where there are several contentious matters that need work.

The most glaring of those is fiscal union.

It is obvious that the rush to create a monetary union did not observe that unless there was a move towards a centrally agreed form of taxation other than VAT, and social benefits were standardized monetary union would be a millstone rather than a benefit.

The creation of a Central Bank to manage the interest rates and the currency has been hampered by the fact that there is no overall Finance Ministry to administer fiscal policy in tandem with monetary policy.

That is why every few years a drama comes along, as was seen with the financial crisis that very nearly saw nations either leave of their own volition or being forced out.

Greece may have turned its finances around extremely effectively, but it is well known that A). They had little option given the level of public debt. B). They would have been unable to access debt markets themselves without support, and C). They will no doubt find themselves in the same position again at some time in the future.

The issue of fiscal union comes to a head when a country like Spain or Italy borrows from the debt market to fund social support for its people.

The rates these countries are expected to pay distort the entire market since the buyers of the debt are fairly sure, no matter the caveats inserted in the documentation, that stronger economies like Germany stand behind them since they are both committed to the success of the Union and want to be seen as standing strong.

The ECB was tasked with supplying support for indebted nations during the Pandemic and this contributed to rising inflation. Now they want to bring inflation lower, but it is difficult for the same borrowers to wean themselves off the support, since they want to keep the same level of social payments to their people.

Without being forced into UK style austerity, this will continue to be a matter for dispute.

The Euro drifted in the financial markets yesterday as traders awaited the result of next week’s interest rate decision.

It climbed to a high of 0.9845 but lacked any follow through and fell back to close at 0.9786.

Have a great day!

Alan Hill

Alan has been involved in the FX market for more than 25 years and brings a wealth of experience to his content. His knowledge has been gained while trading through some of the most volatile periods of recent history. His commentary relies on an understanding of past events and how they will affect future market performance.