UK PMI readings released last week came in below expectations, contrasting with firmer, if lagged, UK hard data. Against stronger Eurozone survey results, sterling continued a gradual decline versus the single currency through much of the week. In rates, gilts outperformed other sovereign markets on a relative basis, a change from recent years that has been linked to the UK offering the highest yields in the G10.
With global bond markets unsettled, attention is turning to next month’s Autumn Budget as the main near-term catalyst for broader UK assets. Yields have been rising, while inflation and government borrowing have also surprised to the upside in recent months, sharpening the policy trade-offs facing Chancellor Healey. The government has indicated that additional tax rises and higher borrowing are likely, leaving market focus on how the fiscal package is presented and whether it avoids concerns about a fiscal doom loop while remaining credible on growth.
Strategies For Sterling Weakness
We suggest derivative traders prepare for continued sterling weakness by buying EUR/GBP call options. This strategy exploits the widening gap between the Eurozone’s resilient survey data and the UK’s disappointing PMI, which recently fell to 49.7. Historically, similar PMI divergences have pushed the pound down by over 2% against the euro within a month.
Portfolio Protection Amid Fiscal Risks
To protect portfolios ahead of the upcoming Autumn Budget, we recommend shorting UK gilt futures. UK 10-year yields are already elevated at 4.25%, and with public borrowing unexpectedly rising to £13.7 billion, the fiscal outlook is fragile. We remember how the 2022 mini-budget caused gilt yields to spike by over 100 basis points, showing how quickly bond markets can punish fiscal missteps by Chancellor Healey.
We also advise buying short-dated GBP/USD straddles to capitalize on the expected rise in sterling volatility. Currently, one-month implied volatility is trading at a quiet 7.1%, which we believe underprices the risks of the upcoming budget. As October approaches and tax hike details emerge, buying this cheap volatility should yield strong returns for option traders.
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