The Pound Sterling (GBP) started as the worst performing G10 currency but ended third worst, affected by initial declines in Gilt yields which later recovered modestly. This movement followed Chancellor Reeves’s speech, implying potential tax increases contrary to election promises, which contributed to a 5bps drop in the 2-year Gilt yield. Reeves’s comments suggested a focus on creating budget headroom to withstand global turbulence, potentially doubling the GBP 10bn headroom from the previous year.

Market Reactions And Fiscal Implications

The markets interpreted this as increasing the likelihood of significant tax hikes, focusing on reducing inflation and easing costs for UK households. However, there may be a strategic element to the speech, setting low expectations to surpass them on budget day. The Resolution Foundation’s pre-budget analysis suggests the fiscal hole may be smaller than assumed, estimated at GBP 14bn rather than GBP 25-40bn.

If the fiscal hole is indeed smaller, the budget might raise enough revenue to increase fiscal headroom without breaching manifesto promises. This could mean the negative market reactions may be exaggerated. Nevertheless, the pound is expected to continue underperforming due to harsh budget expectations, with a 30% chance of a rate cut priced by the market for tomorrow.

Based on yesterday’s speech from Chancellor Reeves, the pound is facing headwinds. The market is interpreting the talk of “tough action” and building “resilient public finances” as a strong signal for upcoming tax hikes. This expectation of fiscal tightening has put immediate downward pressure on GBP.

This cautious government stance comes as we see inflation remaining stubborn, with the latest figures for October showing the headline rate at 2.8%, still above the Bank’s target. Coupled with recent data showing the economy grew by a marginal 0.1% in the third quarter, any aggressive fiscal tightening could risk tipping the economy into recession. This difficult backdrop reinforces the market’s bearish sentiment on the pound for now.

Trading Strategies Amid Sterling Weakness

In the weeks leading up to the budget, derivative traders should consider strategies that benefit from further sterling weakness. We could look at buying put options on GBP/USD or selling futures contracts to capitalise on the expected underperformance. The current market pricing for a Bank of England rate cut tomorrow is only 30%, suggesting monetary policy won’t provide support for the currency this week.

We see this focus on fiscal credibility as a direct response to the Gilt market crisis that occurred back in the autumn of 2022. The Chancellor is clearly aiming to avoid a repeat of that instability by preparing the market for austerity. This makes a Bank of England rate cut this week highly unlikely as they await clarity from the budget.

However, there is a distinct possibility that the government is managing expectations downward to deliver a less severe budget than currently feared. The Resolution Foundation’s analysis suggesting a much smaller £14 billion fiscal hole supports this view. This sets up a potential relief rally, suggesting traders could consider buying call options with expiry dates set after the budget announcement to position for a positive surprise.

Given the high level of uncertainty, implied volatility on the pound is likely to increase as we approach budget day. This presents an opportunity to trade the magnitude of the price move, not just the direction. We could use straddle or strangle option strategies, which would profit from a significant move in the pound whether it rallies or falls sharply on the day of the announcement.

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