The Pound Sterling was recently the weakest among G10 currencies but managed to recover slightly, ending as the third weakest. This change followed a speech by Chancellor Reeves, where she hinted at tough budget measures and potential tax increases, going against prior election promises. After her comments, the 2-year Gilt yield fell by 5 basis points. Financial markets are worried that Reeves’ speech might imply even larger tax increases. Her comments about creating “more resilient public finances” and plans to increase the fiscal buffer beyond last year’s GBP 10 billion added to these concerns. However, Gilts did well thanks to Reeves’ focus on reducing inflation and helping with the UK’s cost of living.

Setting Expectations

Some see the timing of her speech as a way to set low expectations for the upcoming budget. A pre-budget analysis by the Resolution Foundation suggests the fiscal gap could be GBP 14 billion, less than the previously estimated GBP 25-40 billion. If this is correct, it could provide more fiscal space without breaking election promises. The Bank of England is likely to avoid any rate cuts due to budget uncertainties and incoming data. Despite these factors, the pound is expected to struggle amidst budget concerns, with a 30% chance of a rate cut. After the Chancellor’s speech, we view the Pound Sterling as vulnerable in the near term. The market is factoring in the risk of significant tax hikes in the upcoming budget, pushing GBP/USD down towards the 1.2200 mark. This creates a bearish outlook for the pound against its major counterparts. For derivative traders, the uncertainty leading into the budget indicates a rise in implied volatility. We believe strategies that capitalize on price movements, like buying GBP/USD straddles, could work well. This approach allows traders to benefit whether the budget turns out to be surprisingly soft, leading to a relief rally, or if it confirms negative expectations, resulting in a further sell-off.

Fiscal Discipline Commitment

We think the Chancellor’s tough rhetoric is a direct response to the market turmoil following the 2022 “mini-budget.” By emphasizing “resilient public finances,” she aims to prevent another gilt market crisis. While this commitment to fiscal discipline may be tough in the short term, it is intended to reassure long-term investors. However, the backdrop is challenging. Recent data shows UK inflation persisted at 2.4% in October, while Q3 GDP shrank by 0.1%. This mix of slow growth and high inflation complicates the Bank of England’s decisions, likely making strict fiscal measures more necessary as the government tries to assist the central bank in fighting inflation. Yet, there is a chance this is a political strategy to manage expectations. The Resolution Foundation recently estimated the fiscal gap is around GBP 14 billion, significantly lower than the GBP 25-40 billion figures previously suggested. If accurate, the Chancellor might present a budget that is less severe than feared, which could cause a sharp rally in the pound. Given the uncertainties, the Bank of England is almost certain to keep interest rates steady at its meeting tomorrow. Currently, there is only a 30% chance of a cut, and policymakers will likely wait to see the full budget details before making any decisions. We will monitor the 2-year Gilt yields, which are currently around 4.15%, for any changes in sentiment regarding future rate cuts. Create your live VT Markets account and start trading now.

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