Analysis-Market mayhem awaits Britain's new leader

Britain leadership contenders take part in Conservative Party hustings event

By William Schomberg and Dhara Ranasinghe

LONDON (Reuters) - Liz Truss, on course to become Britain's prime minister on Monday, looks set to walk straight into a financial market firestorm that she will have to act fast to extinguish.

The pound had its worst month against the dollar in August since shortly after the Brexit referendum in 2016 and fell against the euro too. Some British government bonds suffered their biggest price losses in decades. Much of the market turmoil is due to a surging inflation rate which is the highest among Group of Seven economies. Goldman Sachs says it could hit 22% if the impact of Russia's invasion of Ukraine on gas prices does not fade.

Many investors are also alarmed that tax cuts promised by Truss could aggravate Britain's inflation problem, speeding up the Bank of England's interest rate hikes and worsening a recession that the BoE expects to start this year and end only in 2024.

As well as tax cuts, Truss has recently promised "robust" direct cost-of-living help for households which would put more strain on the budget deficit.

Then there are her plans to rethink the way the BoE does its job and to be ready to risk a post-Brexit trade war with the European Union.

"I think the UK and the gilt market are in a degree of danger," Mike Riddell, a senior fixed income portfolio manager at Allianz Global Investors in London, said.

He pointed to sharp falls in recent weeks in the prices of British government bonds, or gilts, and the value of sterling, a rare occurrence.

Normally, the prospect of higher BoE interest rates would hurt demand for bonds while pushing up the pound but the currency is down 15% against the U.S. dollar so far this year.

Until August, there had never been a month when sterling fell by as much as 4.5% against the dollar and 10-year gilt yields rose by more than 90 basis points, according to Refinitiv and Bank of England data going back to 1971 when sterling floated.

"The breakdown in the relationship between gilt yields and sterling is indicative of overseas investors losing confidence in the UK, and that is what is really worrying," Riddell said.

SMASH THE ORTHODOXY

Opinion polls have given Truss - currently Britain's foreign minister - a big lead over Rishi Sunak, who quit as finance minister in July to contest the Conservative Party leadership race which ends on Monday with an announcement of the winner.

As a former chief secretary to the Treasury, Truss says she knows how to shake up economic orthodoxy by cutting Britain's tax burden which is heading for a 70-year high.

Sunak has dismissed her tax cut plans as "fairy tales" which will fuel inflation.

Asset management firm Pictet said this week it was underweight on gilts due to the risk of a big stimulus push which could force the BoE to accelerate its rate hikes.

Julian Jessop, an economist who backs Truss and is close to her advisers, said the idea of borrowing more now to speed up future economic growth made sense.

"In these circumstances, you need to be bold and flexible on fiscal policy and if that means that in the short term the budget deficit has to take strain, then so be it," he said.

Britain's public finances are weighed down by the government's huge coronavirus spending spree.

Public debt as a share of economic output is not far off 100%, up from about 80% before pandemic.

But Jessop, a fellow at the Institute for Economic Affairs think-tank, said Truss was probably looking at extra borrowing in the tens of billions of pounds, far less than during the COVID-19 pandemic, something financial markets could swallow.

"Once she actually gets the keys to Number 10 (Downing Street) then she can start reassuring markets about what she actually intends to do," he said.

KINDNESS OF STRANGERS

For some investors, that kind of clarification cannot come a moment too soon, with Riddell noting that a planned sale of a big slug of 30-year gilts in mid-September will be a test for Britain's debt office.

Oliver Blackbourn, U.K. portfolio manager at Janus Henderson Investors, said there were also political risks for Truss, who stands to become Britain's fourth prime minister in six years.

She trailed other candidates for much of the Conservative Party leadership race when it was in the hands of party lawmakers, climbing into second place at the last minute to contest the run-off, which is being decided by party members.

"How easy is it going to be for her to control her party in the House of Commons when she wasn't anywhere near the most popular choice among members of parliament?" Blackbourn said.

"When you have hard decisions to make, you want to have a strong leader in place."

For Jessop, the Truss-supporting economist, the first item on her agenda if she is announced as prime minister on Monday should be a promise not to meddle with the BoE's independence.

Truss has said she wants to review the central bank's mandate without compromising its independence but one of her supporters has questioned whether the BoE should have exclusive powers to set interest rates.

"It's very important that she hit the ground running with a clear statement of policy," Jessop said.

(Additional reporting by Andy Bruce and Humza Jilani; Writing by William Schomberg; Editing by Philippa Fletcher)