Truss could announce cap to energy billsSignificantly limiting inflationary pressuresAnd saving economic growthCould support GBP into year end

Above: Liz Truss speech having won the leadership contest. Image: The Conservative Party / Ben Stevens / Parsons Media.

The British Pound has had a torrid 2022 but could find redemption in the final months of the year if the new prime minister is able to deliver a compelling set of measures to ease the cost of living crisis.

A number of media outlets are reporting Truss - who will assume the role of Prime Minister Tuesday - could deliver a programme to cap energy bills to the tune of £130BN.

She is also anticipated to announce tax cuts as part of one of her key campaign pledges.

The Pound had fallen to its lowest level since 2020 against the Dollar on the day it was announced Truss had beaten Rishi Sunak in the leadership race.

But with a new government about to take the reins the UK economic outlook is set to shift, potentially onto a more constructive course.

"A leadership change may improve GBP sentiment, as planned tax cuts by the likely Truss government promise to lift investment. However, macro headwinds will dominate in the short to medium term," says David Alexander Meier, an economists at Julius Baer.

Julius Baer says an upside risk for the Pound is that fresh cost-of-living measures cushion consumers from higher energy prices and support growth.

The Pound to Euro exchange rate traded at its lowest level since June at 1.1525 last week, with the Pound to Dollar exchange rate hitting its lowest level since March 2020 at 1.1444 on Monday. (Protect against further losses by locking-in today's exchange rate).

Sterling has looked particularly weak amidst an ongoing global stock market selloff, which creates conditions that traditionally challenge the Pound.

But, a surge in UK gilt yields as investors sold UK government bonds, suggested investors were increasingly uncomfortable holding UK debt and UK assets in general.

Above: The yield paid on UK government debt (gilts) that is redeemed in two years.

This as they fear the cost of the UK's debt burden might become unsustainable given Truss' plans to increase spending and cut taxes.

"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 UK economy," says Susannah Streeter, senior investment and markets analyst at Hargreaves Lansdown.

"Expectations that a Trussenomics solution will be found by slashing taxes and spending big is fuelling worries that inflation will not easily be brought under control and that the Bank of England will be forced to keep raising rates and keep them elevated for longer," adds Streeter.

But Truss is expected to adopt a 'growth at all costs' economic policy, in the hope that economic rejuvenation can quell investor fears about the sustainability of UK debt levels.

"Strong chance dip buyers emerge for GBP this week. Markets are pricing in a BoP / fiscal crisis narrative already on the back of Truss. But sensible govt policy that eases stagflation crisis and reduces the need for sharp BoE hikes and lowers deep recession risks is good for pound," says Viraj Patel, a strategist at Vanda Research.

Above: GBP/EUR (top) and GBP/USD (bottom) at daily intervals. Set your FX rate alert here to stay on top of the market.

GBP/EUR fell to a low of 1.1542 earlier Monday before recovering to 1.1625 by Tuesday, taking bank account exchange rates for euro payments to around 1.1390 and quotes at specialist payment providers to 1.1590. GBP/USD fell to a new 2022 low at 1.1442 Monday before recovering to 1.1570, meaning bank accounts were quoting around 1.1340 for dollar payments and payment specialists at around 1.1535.

The UK's new Prime Minister is considering freezing energy bills for millions of households this winter according to reports, a decision that could slash the UK's inflation rates by as much as four percentage points.

But core inflation would nevertheless remain stubbornly high and invite further Bank of England interest rate hikes, according to independent research providers Capital Economics.

Ahead of confirmation Truss had won the contest for the next leader of the Conservative Party, the Telegraph reported a freeze on bills of some form is now expected.

"The implications would depend on the detail, but it could mean that CPI inflation is something like 4 percentage points lower than otherwise," says Paul Dales, Chief UK Economist at Capital Economics, of an energy bill cap.

Above: The Bank of England's UK inflation forecast as of August 2022.

This means inflation might may rise from 10.1% in July to a peak of 10.5%, rather than 14.5% Capital Economics are currently forecasting.

"For GBP the emphasis is very much on fiscal policy. Further support is needed for both households and businesses, but for foreign investors financing it, it needs to be targeted rather than blanket," says Simon Harvey, Head of FX Analysis at Monex Europe.

Another issue that has been dragging down sentiment on Pound Sterling is the future of the Bank of England under a Truss premiership.

Truss had said she wanted to review the Bank's mandate during her campaign, leading some economists to warn on the outlook for UK assets, including the Pound.

"We expect a coming War of Independence over the Bank of England. This potential tussle and the politicisation of the UK's central bank is likely to create considerable uncertainty which will spook financial markets," said Nigel Green, chief executive and founder of deVere Group.

"We can expect the pound and the gilt market to react badly to any sense of growing political interference," he added.

However, writing in the FT, Kwasi Kwarteng, who is heavily favoured to be the country's next Chancellor, said "we also remain fully committed to the independence of the Bank of England".

Kwarteng acknowledged "the important job" the Bank "have in the months ahead to bring down inflation. We believe co-ordination across monetary policy and fiscal policy is crucial."

"Forecasts are not destiny," adds Kwarteng. The Bank of England dominated newspaper front pages in August when it released forecasts showing inflation would rise to "around 13%" before the end of 2022.

Above: Bank of England GDP forecasts show an effective ending of UK economic growth.

They also forecast the UK would slip into a recession by year-end and it would not escape the clutches of 0% growth until at least 2025.

Analysis from Capital Economics meanwhile finds the peak in inflation and dip in economic growth will be shallower if Truss does proceed with an energy bill cap.

"The implications would depend on the detail, but it could mean that CPI inflation is something like 4 percentage points lower than otherwise," says Dales of an energy bill cap.

This means inflation might may rise from 10.1% in July to a peak of 10.5%, rather than 14.5% Capital Economics are currently forecasting.

It is estimated any plan to cap prices would cost £70-100bn, or 3-4% of GDP, which would be financed through borrowing.

In October the average annual energy bill will jump from £1,971 to £3,549 which would lead to a spike in inflation.

The Bank of England said in August it expects UK inflation would now peak "around 13%".

Should energy bills be capped, Capital Economics says real GDP wouldn't "fall as far".

"We doubt Truss will be able to prevent a recession. But her policies could limit its depth and length. Our current forecasts envisage real GDP fall by around 1% from its peak to its trough over a the course of a year," says Dales.

Selling the Pound has been seen as a hedge against stagflation over recent months, given expectations for the UK to be one of the worst hit economies from rising inflation.

Should Truss successfully prevent this, the Pound could look cheap again and a stronger finish to the year therefore becomes a possibility.