What Liz Truss's premiership means for bonds

Truss, who was elected Conservative Party leader on September 5, will become prime minister tomorrow but faces a monumental task upon taking office, given the cost of living crisis the UK is facing and the recession forecast by the Bank of England.

She has already pledged £30bn of tax cuts and to borrow more to plug the hole in funds.

As many of Truss's pledges are unfunded, at rising interest rates this could mean a costly debt burden for the UK economy, whose public sector net debt already runs at 96 per cent of GDP, according to the ONS.

So-called Trussenomics - cutting taxes and spending big - is fuelling concerns that inflation will take longer to be brought back under control, meaning rates will rise faster and stay high for longer.

Bond markets already reacted in the run-up to her arrival, with the yield on 10-year government debt heading towards 2.92 per cent and remaining more or less unchanged since her appointment was confirmed.

If the financial markets like what they hear then that may help to hold gilt yields in check. If not, then yields could rise, the curve continue to invert and sterling may keep sliding.AJ Bell's investment director Russ Mould

Susannah Streeter, senior investment and markets analyst at Hargreaves Lansdown, said: "Truss and her preferred candidate for chancellor, Kwasi Kwarteng, are much more relaxed about higher levels of borrowing than their predecessors and that continues to cause jitters in financial markets.

"The pound is still hovering near 2.5 year lows at $1.15 while the yields on UK 10-year government debt are little changed at 2.93 per cent.

"Yields have registered the biggest monthly rise since 1986 as Liz Truss hurtled towards Downing Street, throwing out promises of slash and spend on the campaign trail, which threaten to cause fresh problems for the UK economy."

Dan Boardman-Weston, chief executive and chief investment officer at BRI Wealth Management, agreed with Streeter's views, saying the announcement had been expected, meaning it had been priced in.

He said the impact on equity, bond and currency markets had therefore been limited today, though sterling and gilts have been "very weak" over the last month.

Daniele Antonucci, chief economist and macro strategist at Quintet Private Bank, said gilt yields would continue to rise on ongoing Bank of England rate hikes and given the potential for Truss’s tax cuts to be mostly unfunded.

He said: “It looks as if Truss will likely prioritise boosting economic growth rather than redistributing wealth. While the most important thing when it comes to supporting economic activity is a range of structural reforms, which could perhaps end up being market moving especially for equities and the currency, the details are very important here and this is what the market will likely focus on going forward.

"For bond markets, the detailed funding plan, along with the credibility of government debt and deficit projections, is likely to be important too."

AJ Bell's investment director Russ Mould said: "If Liz Truss can put an end to the sell-off in both the UK government bond market and sterling that would be a major coup," though he too said the odds were very much stacked against her.

He added: "Sterling may be sliding but government borrowing costs are soaring, to suggest that the bond market does not think too much of what it sees in the UK, either – although the Bank of England’s interest rate rises in its belated battle to rein inflation back in has a big role to play here, too."

UK 10-year gilt yields, though low by historic standards, are within touching distance of the 3 per cent mark for the first time since early 2014, he said.

Recession ahead?

The yield curve is now inverted, meaning in August the yield on the two-year gilt moved up faster than that of the 10-year, meaning the shorter-term paper offered a higher yield.

“This is usually a sign that the bond market is pricing in a recession, as it anticipates future interest rate cuts, and thus a drop in borrowing costs," said Mould.

“It is by no means a flawless indicator – nothing is ever that easy from an investment point of view – but the UK yield curve inverted ahead of the 1991-92 downturn and the deeper 2007-09 recession.

"While the inversions of 1998 and 2000 proved false signals, they did reflect concerns over the potential for the stock market’s bust in technology, media and telecoms stocks to spill into, and weigh on, the real economy."

He added: "The new prime minister will find themselves potentially trapped between the lesser of two evils of inflation on one side and recession on the other.

"If the financial markets like what they hear then that may help to hold gilt yields in check, the yield curve to steepen and the pound to rally. If not, then yields could rise, the curve continue to invert and sterling may keep sliding."

Quintet Private Bank recently downgraded its growth forecasts and expects the UK to enter recession in the final month of the third quarter of this year (September) or in Q4, with overall economic activity contracting for about three quarters in a row.

Antonucci said: "While not a done deal, we believe that a 50bps rate hike to 2.25 per cent at the September 15 monetary policy meeting of the Bank of England is likely, though a step-up to 75bps is possible too.

"Even though we expect a 50-75bps rate hike to 0.50-0.75 per cent on September 8 for the European Central Bank too, the bigger/faster fiscal stimulus in the UK and the somewhat milder recession we envisage in the UK would suggest more upside risks to the Bank of England rate path versus the European Central Bank.”

A 'different' PM

Walid Koudmani, chief market analyst at financial brokerage XTB, said the country could yet see a different Liz Truss to the one on the campaign trail.

"There is certainly a degree of uncertainty over the economic plan under prime minister Liz Truss. This is why investors are selling out of the pound aggressively and why UK bond yields are racing higher, He said.

"Of course, now that Truss has won the premiership, we might see a different Truss to the one campaigning to become Conservative leader.

"This might mean her policies could be toned down somewhat and if we start to see moves such as this, it will likely make investors more comfortable."

He said earlier comments about changing the Bank of England's mandate are already being rolled back.

"The independent Bank of England is a beacon to the stability of the UK for foreign investors. If the role of the Bank is amended or their ability to set interest rates independently of the government is changed, it would dramatically alter how international markets view the UK's financial landscape and not in a good way.

"Comments from Truss and her supporters over the weekend have diluted her ambitions on the Bank's role it seems."  

carmen.reichman@ft.com