The Pound Sterling was initially the worst performing G10 currency recently, though it ended third worst after some recovery. This occurred following a speech by Chancellor Reeves suggesting tough budgetary actions and implying potential tax increases, contrary to election promises. The 2-year Gilt yield initially dropped by 5bps, reacting to the implied announcements.

There is concern that the financial markets saw Reeves’ speech as indicating possible larger tax hikes. This was compounded by her remarks about building “more resilient public finances” and suggestions of increasing the fiscal buffer beyond the GBP 10bn from last year. Gilts performed well on Reeves’ focus on reducing inflation and easing the cost of living in the UK.

Setting Expectations

The timing of the speech is interpreted by some as setting low expectations to surpass on budget day. Meanwhile, a pre-budget analysis by the Resolution Foundation suggests the fiscal hole might be GBP 14bn, smaller than the previously estimated GBP 25-40bn. If correct, this could allow increasing fiscal headroom without breaching election promises. The Bank of England is expected to refrain from any cuts due to budget uncertainties and incoming data. Despite these developments, the pound is anticipated to underperform amid budget expectations, with a 30% chance of a rate cut.

Based on the Chancellor’s speech yesterday, we see the Pound Sterling as vulnerable in the immediate future. The market is pricing in the risk of significant tax hikes in the upcoming budget, pushing GBP/USD towards the 1.2200 handle. This creates a clear short-term bearish bias for the pound against its major peers.

For derivative traders, this heightened uncertainty leading into the budget suggests a rise in implied volatility. We think strategies that benefit from price swings, such as buying GBP/USD straddles, could be effective. This allows a trader to profit whether the budget delivers a surprisingly soft outcome causing a relief rally or confirms the market’s worst fears and triggers a further sell-off.

Fiscal Discipline Commitment

We believe the Chancellor’s tough talk is a direct response to the market chaos seen after the 2022 “mini-budget.” The focus on building “resilient public finances” is a deliberate signal to avoid a repeat of that gilt market crisis. This commitment to fiscal discipline, while painful in the short term, is designed to reassure long-term investors.

The backdrop for this is challenging, as recent data showed UK inflation remained sticky at 2.4% in October while Q3 GDP contracted by 0.1%. This combination of sluggish growth and persistent inflation complicates the Bank of England’s path forward. It makes a harsh fiscal consolidation more likely as the government tries to help the central bank in its fight against inflation.

However, there is a chance this is a political strategy to manage expectations. The Resolution Foundation recently estimated the fiscal hole is closer to £14 billion, far less than the £25-40 billion figures being circulated. If they are right, the Chancellor could deliver a budget that is less severe than currently feared, which would likely cause a sharp relief rally in the pound.

Given the uncertainty, the Bank of England is almost certain to hold interest rates steady at its meeting tomorrow. The market currently implies only a 30% chance of a cut, and policymakers will want to see the full details of the budget before making any move. We will be watching 2-year Gilt yields, now hovering around 4.15%, for any shift in sentiment regarding future rate cuts.

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