Financial markets greeted the arrival of the UK’s new PM with a shrug. The weakness of the pound, a feature for much of this year, continued, showing Liz Truss that restoring faith in UK assets would not be easy. The question for investors appears to be ‘how low can it go?’.

The weakness of sterling is not entirely a reflection of the UK’s general malaise. The Euro is also down substantially against the Dollar. The Dollar’s recent surge has come about primarily as a result of the Federal Reserve’s commitment to raising rates in the face of persistent inflation. However, the general risk aversion in markets has also steered investors towards the Dollar, as a ‘safe haven’. 

The two elements that could reverse sterling weakness are strength in the UK economy, or – more likely – some sign that the Federal Reserve is changing course. Europe and the UK may be harder hit by rising energy prices, but domestic sources of inflation are far stronger in the US. US domestic inflation is supported by continued strength in the labour market. The US economy added 528,000 jobs in July and a further 315,000 in August. Economists have suggested this would need to fall to 100,000 for the Fed to reconsider its position. 

The UK is unlikely to see any significant progress in the near-term. It has a vast current account deficit. The new Prime Minister has said she will launch a package to tackle the energy crisis within days, which may help stave off recession. However, Truss’s dismissal of ‘treasury orthodoxy’ suggests they may play fast and loose with the UK’s finances in an attempt to stimulate growth. It might work, but it could be a disaster.  In this case, sterling may weaken further. 

The most likely scenario is that Dollar strength ebbs a little, but remains a feature. Oxford Economics says interest rate differentials and global liquidity conditions are likely to remain supportive of the Dollar for some time, but factors such as relative growth and stock price performance could exert a short-term drag. The group says that the Dollar looks over-valued, but may stay over-valued for some time. 

There is talk that the pound could reach parity with the Dollar from its current level of $1.15. That prediction looks like an outlier in the short-term, but it remains a possibility if Liz Truss can’t find a way to revive the UK economy and restore faith in UK assets.