Pound Sterling Drops after Kwarteng Fired, Truss Speech Up Next

• GBP lower today, Kwarteng fired
• GBP had surged Thursday on mini-budget u-turn rumours
• Pound to Euro @ 1.1198, down 0.40% today
• Pound to Dollar @ 1.1522, down 0.90% today
• Corporation taxes could rise says report
• Downside risks if rumours prove unfounded

Above: Kwarteng is to cut short his trip to Washington to potentially announce a policy shift. Image: Gov.UK

The British Pound fell on Friday following news Chancellor Kwasi Kwarteng had lost his job as Prime Minister Liz Truss proceeds with an overhaul of her government's fiscal policy.

Kwarteng returned from an IMF event in Washington a day earlier than scheduled as the government moved to restore market confidence following a tumultuous couple of weeks.

Number 10 has confirmed Jeremy Hunt, a former health secretary and supporter of Rishi Sunak in the Conservative leadership election, has been appointed Chancellor of the Exchequer.

Truss is to give a press conference at 2PM.

The Pound had earlier rallied to its highest level in over a month against the Euro while it recovered to its highest level in a week against the Dollar, amidst reports the UK government was set to reverse some, or all, of its mini-budget.

"The GBP has emerged as the best performing G10 currency so far this week following more U-turns by the Truss government in recent days," says Valentin Marinov, Head of G10 FX Strategy at Crédit Agricole.

The Pound rallied through Thursday as a number of mainstream media outlets reported a "mother of u-turns" was highly likely, suggesting Downing Street was testing out the idea.

If the government wanted a fall in UK bond yields and a rising Pound, the idea has received a thumbs-up.

"The Pound soars for a change," says Chris Beauchamp, chief market analyst at IG. "It looks like the market is pricing in a rising probability that a major u-turn (and even potentially several u-turns) are likely, improving the UK’s fiscal outlook while simultaneously leaving the new PM and her chancellor looking like they are unable to control events."

Key to the Pound's recent recovery has been bond market dynamics, where bond yields have fallen back sharply this week.

In fact, the yield on 5-year bonds has fallen back to levels similar to those seen in the U.S. as investors buy up these bonds again.

"There have been media reports of a possible U-turn by the government. If it is perceived to go far enough by markets to restore fiscal credibility, this could improve the outlook for numerous assets," says Philip Shaw, Economist at Investec.

As the chart below shows, U.S. bonds were yielding more than their British counterparts ahead of the mini-budget of September 23.

Above: UK five-year bond yields (blue) vs. their U.S. counterpart.

Before the mini-budget U.S. bond yields were higher as investors anticipated higher interest rates at the U.S. Federal Reserve relative to what the Bank of England was likely to deliver.

But the spike in UK yields following the mini budget suggests investors made it clear they now demanded a premium to hold UK assets, fearing the unfunded tax cuts would compromise UK fiscal stability.

This risk premium in UK bonds was also evident in the Pound, which fell as UK bond yields soared.

"A key error of judgement by PM Liz Truss and Chancellor Kwasi Kwarteng was their focus on voters as the key stakeholder group with whom they were prepared to be ‘unpopular’ in the pursuit of their longer-term goals, without regard to the important constituency of financial markets as another key stakeholder," says Shaw.

But, the recent decline in UK bond yields suggests some of that risk premium is being unwound, and it is also reflected in the value of the Pound.

For the Pound to hold ground the government must now deliver on the u-turn. "Needless to say, any disappointments could see the GBP reversing the recent gains," says Marinov.

The above chart also tells us that not all that risk-premium has unwound, therefore the market could be wary that the news out Thursday were rumours that would ultimately prove unfounded.

It could however also suggest the market expects only part of the mini-budget to be unwound.

Therefore, Truss could get away with potentially keeping some aspects of the budget and jettisoning, or delaying, others.

But, according to the Sun's Political Editor, Truss is in fact considering raising Corporation Tax next year "in a spectacular mini-Budget u-turn".

Former Chancellor Rishi Sunak's was set to hike corporation tax from 19 to 25% next April, something Truss said she would reverse.

But the same reporter says another of his Downing Street insiders said "it will not go all the way up to 25 per cent" and Britain will "remain competitive on the international stage".

For foreign exchange analysts, the Pound's ability to recover, or maintain recent gains, depends on the government now following through with some sort of u-turn.

"Without Downing Street back-paddling I find it difficult to imagine how Sterling should recover on a sustainable basis," says Thu Lan Nguyen, FX and Commodity Analyst at Commerzbank.