The Pound Sterling (GBP) started off as the weakest currency among the G10 but ended up slightly better as Gilt yields dropped initially but then recovered a bit. This change followed Chancellor Reeves’s speech, which hinted at possible tax increases that contradicted past election promises. This announcement contributed to a slight 5bps drop in the 2-year Gilt yield. Reeves’s remarks indicated a goal to create a fiscal buffer to handle global challenges, potentially doubling last year’s GBP 10bn headroom.

Market Reactions and Fiscal Implications

Markets took this as a sign of possible significant tax increases aimed at lowering inflation and helping UK families with costs. However, it may also be a strategic move to set low expectations, allowing them to exceed those on budget day. The Resolution Foundation’s analysis before the budget predicts the fiscal shortfall may be only GBP 14bn instead of the earlier estimate of GBP 25-40bn. If the fiscal shortfall is smaller, the budget could raise enough funds to increase fiscal space without violating manifesto promises. This could mean the negative market reactions might be overblown. Still, the pound is likely to remain weak due to strict budget forecasts, with a 30% chance of a rate cut anticipated by the market for tomorrow. Based on Chancellor Reeves’s recent speech, the pound is facing challenges. The discussion of “tough action” and building “resilient public finances” suggests tax hikes are on the horizon. The expectation of tight fiscal policies has put downward pressure on GBP. This cautious government approach comes as inflation stays stubborn, with October’s headline rate at 2.8%, above the Bank’s goal. Meanwhile, the economy grew just 0.1% in the third quarter. Any aggressive tightening could push the economy into recession, reinforcing the market’s negative outlook on the pound.

Trading Strategies Amid Sterling Weakness

In the weeks leading to the budget, derivative traders should think about methods that benefit from further GBP weakness. Buying put options on GBP/USD or selling futures contracts could capitalize on this expected decline. The market currently sees only a 30% chance of a Bank of England rate cut tomorrow, indicating that monetary policy isn’t likely to support the currency this week. This emphasis on fiscal credibility is a response to the Gilt market crisis from autumn 2022. The Chancellor aims to prevent a repeat of that instability by preparing the market for austerity, making a rate cut from the Bank of England this week unlikely as they await clarity from the budget. However, the government might be lowering expectations to produce a budget that is less severe than feared. The Resolution Foundation’s estimate of a GBP 14 billion fiscal gap supports this idea. This could create a potential relief rally, suggesting that traders might want to consider buying call options that expire after the budget announcement in hopes of a positive surprise. As uncertainty remains high, implied volatility for the pound is likely to rise as we approach budget day. This creates the chance to trade on the size of price movements, not just their direction. Straddle or strangle option strategies could be used to profit from a significant move in the pound, whether it rallies or drops sharply on budget day. Create your live VT Markets account and start trading now.

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