A Fragile Backdrop for a Critical Budget  

The UK enters the Budget week with a growing sense of unease. Recent economic data have painted a picture of an economy losing momentum, households and businesses turning cautious, and markets increasingly sensitive to fiscal signals. While inflation is finally easing, the backdrop against which the Chancellor will set out fiscal plans is anything but comfortable.

Growth Stumbles as Confidence Fades

Growth figures for Q3, released earlier this month, came in below economists’ expectations (1.3% vs. 1.4%). Some of the weakness reflects a one-off hit to manufacturing caused by the cyberattack at Jaguar Land Rover, but the broader message is more troubling: underlying momentum is slipping.

Consumer spending—long the engine of the UK economy—remains muted. The latest data show quarter-on-quarter growth of just 0.2%, continuing a pattern of weakness. Simultaneously, the number of homes being put up for sale has fallen for a third consecutive month, and business sentiment remains firmly in negative territory. Nerves about the economic outlook are clearly widespread.

This retrenchment in spending is particularly concerning given that real incomes have been ticking higher in recent months. That tailwind, however, may not last.

Labour Market Cools, Wage Growth Eases

Signs of a cooling labour market are becoming harder to ignore. So far this year, the economy has shed roughly 180,000 jobs. While the drop is less severe than initially forecast following Chancellor Rachel Reeves’ National Insurance hike, it is nonetheless a meaningful deterioration. The unemployment rate has climbed to 5%, now just 0.3 percentage points shy of its Covid-era peak.

As labour market slack opens, wage inflation is easing. Recent data show wage growth cooling to 2.7% on a quarterly basis—below the 3% pace that many economists associate with 2% headline inflation. This marks a rare piece of “good news/bad news” for the Bank of England: easing wage pressures help the inflation fight but signal weakening demand.

Inflation Finally Turns Lower

After September’s 3.8% inflation print, Bank of England Governor Andrew Bailey hinted that inflation may have peaked and that rates were likely to drift lower. The data released last week support that view.

Headline CPI fell to 3.6% and core CPI eased to 3.4%, marking the first decline in seven months. Most importantly for policymakers, services inflation—a metric closely monitored by the BoE—came in lower than expected at 4.5%.

“This fall in inflation is good news for households and businesses across the country, but I’m determined to do more to bring prices down,” the Chancellor said in response—signalling that inflation remains politically charged even as it cools.

Monetary Policy: Easing Ahead, but How Much?

Current rates market pricing reflects expectations for continued easing by the Bank of England. There is now an 85% probability of a rate cut in December, though only one further cut is fully priced by end-2026. That would leave Bank Rate hovering near 3.5%.

By contrast, the US is priced for roughly 3.5 cuts over the same period.

Rate-cut expectations have firmed in recent months—an extra cut has been added since mid-October—but we believe the risks still skew towards more easing rather than less. The question is: what’s holding markets back? The answer lies squarely with fiscal policy.

Budget Volatility: Markets on Edge

The 26^{th of} November Budget is the key event on the immediate horizon, and market nerves are already palpable. Recent reports that Chancellor Reeves intends to honour her manifesto promise not to raise income tax triggered a sharp reaction. Gilt markets worried about the government’s ability to maintain fiscal discipline panicked and 30-year yields surged almost 20 basis points by the end of the day.

Lower taxes may be politically popular, but investors are asking deeper questions:

• How will the revenue shortfall be plugged? Are the forthcoming OBR forecasts sufficiently optimistic to mask the gap?
• Will the government rely on other, more distortive taxes that could weigh on business competitiveness and long-term growth?
• Is the government prioritising short-term political gain over long-term economic foundations?

These concerns underscore why markets remain cautious in pricing aggressive BoE easing: a fiscally loose Budget could complicate the inflation trajectory and keep rates higher than they otherwise would be.

A Pivotal Week for Sterling

As we approach a critical event in the UK economic calendar, risks seem skewed for Sterling. Though GBP has struggled against USD since the middle of the year and, since late last year against the Euro, it remains somewhat supported by elevated rates. We see a strengthening argument that the pound will continue to weaken in the months ahead.

If Reeves delivers a budget that does not stoke fresh inflation fears, it should clear the way for the BoE to act more decisively to support the sputtering economy. If she missteps and spooks markets – with increased unfunded spending or aggressively anti-growth taxes - we may see higher rates for longer (particularly at the long end). But investor confidence would surely take another leg lower, and a GBP asset dump follow.

We often look to market positioning when considering further moves in currencies – if everyone is already short GBP, who is left to sell? In this instance, however, nothing jumps out from our usual measures, removing yet another potential source of support.

Positioning and Hedging: Caution, but not Capitulation

Whilst we think it prudent to take outstanding GBP exposure off the table ahead of Wednesday, we prefer a shorter hedge tenor for now. Costs remain high to hedge back to EUR and, whilst one-year hedges against USD have reduced in cost in recent weeks, we believe there is further to go – potentially even back to “pick-up” territory in the coming months if the BoE is freed up to enter a more aggressive easing cycle.

This week’s Budget will set the tone for how fiscal and monetary policy interact in the coming years. With markets already jittery, the stakes for a credible, coherent strategy have rarely been higher.