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New UK Prime Minister Liz Truss enters office facing several major crises.
Source: Bank of Singapore, Bloomberg.
Firstly, a large fiscal response to the energy crisis will be announced this month. Relief for low-income households, national insurance contribution (NIC) cuts and lower taxes on utility bills are likely. Caps on energy prices may also be considered.
Secondly, the large extra government borrowing needed to fund the measures, potentially GBP50 billion initially, may worsen inflation. We expect the Bank of England (BoE) to respond with 50bps rate hikes at its September and November meetings before slowing UK growth causes the BoE to step down to a 25bps hike in December. Its Bank Rate may thus rise from 1.75% to 3.00% by year end.
Thirdly, despite larger BoE rate hikes, the outlook for the GBP remains bearish. The chart shows the GBP has hit two-year lows below 1.15 against the USD, close to our three-month forecast of 1.14. And the GBP has been as low as 1.05 in 1985.
The risks for GBP and UK assets still seem skewed to the downside. A deeper recession may occur in 2023 if inflation surges far over 10%. Recession may also make the BoE stop hiking before the Federal Reserve, leaving its Bank Rate below the fed funds rate. Last, the UK current account deficit at a huge 8% of GDP, puts the GBP at risk if capital inflows dry up. This month, PM Truss may decide the UK should over-ride its EU exit treaty regarding trade with Northern Ireland. This could spark strong retaliation from the EU. An EU-UK trade war would hurt sentiment sharply and risk the GBP revisiting its 1985 lows against the USD.
This article was first published by Bank of Singapore on September 6, 2022. The Opinions expressed in this publication are those of the authors. They do not purport to reflect the opinions or views of Bank OCBC NISP Private Banking Tbk. or its affiliates.
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