The absence of a sell-off suggests a widespread assumption that the process of finding a new leader – which is expected to take at most a week – won’t deliver any more political uncertainty, on top of what the UK is already suffering. We see the risk of an election before January 2025 is clearly rising.
Gilts are likely to continue to trade with a sizeable political risk premium for the foreseeable future. At just above 50bp, it is already less than half of what it was in the aftermath of the 'mini' budget, which did so much damage in late September. The old adage, that it takes years to build confidence but only one day to destroy it, applies here. At most, 10Y gilts can hope to tighten another 50bp against German Bunds and US Treasuries but the pace of gains is likely to be much slower from now on. The most compelling question is whether sterling needs to completely unwind the losses imposed by Trussonomics. We had felt that the starting point for this influence on FX markets was in early August when it looked as though Liz Truss was becoming the Tory membership’s top choice for PM. At the time GBP/USD was trading near 1.20 and EUR/GBP near 0.84.
Arguing against Cable returning to 1.20 is the fact that US real interest rates have climbed substantially since then, where the real 10-year Treasury yield now sits at 1.70% versus 0.50% in early August. Equally, it is questionable whether the new UK leadership team can fully regain lost fiscal responsibility even though we presume they will attempt to present a balanced budget on Oct 31st
- ING FX Strategy
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