Deutsche Bank says risk of a ‘sterling crisis’ is rising as Truss becomes UK prime minister

Following the news that Liz Truss will become Britain’s new prime minister, Deutsche Bank says policy announcements in the coming weeks will be crucial if the U.K. is to avoid extreme macroeconomic events, particularly a balance of payments crisis.

Truss won the race to succeed Boris Johnson as leader of the ruling Conservative Party on Monday, following a drawn-out contest against former Finance Minister Rishi Sunak. Truss got 81,326 votes from Conservative Party members, while Sunak got 60,399.

Sterling was fractionally higher against the dollar on Monday afternoon, trading just below $1.15, but Deutsche Bank FX Strategist Shreyas Gopal warned that the risks of a “sterling crisis” should not be underestimated.

“With the current account deficit already at record levels, sterling requires large capital inflows supported by improving investor confidence and falling inflation expectations. However, the opposite is happening,” Deutsche Bank said in a note Monday.

“The U.K. is suffering from the highest inflation rate in the G10 and a weakening growth outlook. A large, unfunded and untargeted fiscal expansion accompanied by potential changes to the Bank of England‘s mandate could lead to an even bigger rise in inflation expectations and — at the extreme — the emergence of fiscal dominance.”

Truss put the Bank of England and its Governor Andrew Bailey firmly in the crosshairs during her leadership campaign, blaming the central bank for allowing inflation to soar to 40-year highs, and is reportedly considering a review of the Bank’s mandate.

She has also suggested scrapping the Northern Ireland protocol, a key part of the post-Brexit withdrawal agreement between the U.K. and the European Union, a move likely to prompt retaliation from the bloc.

Gopal suggested that added uncertainty on trade policy would further muddy the macroeconomic picture and dent investor confidence.

“The risk premium on UK gilts is already rising, coincident with unusually large foreign outflows. If investor confidence erodes further, this dynamic could become a self-fulfilling balance of payments crisis whereby foreigners would refuse to fund the U.K. external deficit,” he said.

Deutsche Bank estimates that trade-weighted sterling — a measure of the pound’s value against selected currencies most important to international trade — would have to come down by a further 15% in order to return the U.K.’s deficit to its 10-year average.

“A balance of payments funding crisis may sound extreme, but it is not unprecedented: a combination of aggressive fiscal spending, severe energy shock, and a slide in sterling ultimately resulted in the U.K. having recourse to an IMF loan in the mid 1970s,” Gopal said.

“Today, the UK does retain some key lines of defense against a sudden stop, but we worry that the risks are rising nevertheless.”