Sterling’s Squeeze: Public Finances in the Frame

Last month, we published a piece (here) highlighting the dilemma facing the Bank of England which resulted in a three-way split vote. Votes had to be recast before a decision to cut the base rate by 25bps could be reached. A month on, the outlook for the UK economy remains just as blurry - if not more so.

With the Bank of England not scheduled to meet again until 6^th November, the focus this week switches to politics and the Labour Party’s conference in Liverpool. From a markets’ perspective, particular attention was paid to Chancellor Rachel Reeves’s speech on Monday for any hints as to what we can expect to be announced in November budget. She highlighted that the Government is facing difficult choices but promised not to take risks with the public finances. She pledged to keep taxes, inflation and interest rates as low as possible, while noting that choices have been made harder by international events and the long-term damage done to the economy under the previous government.

Tax, Spend, or Both?

Either tax rises or spending cuts (or both) will be needed if Reeves is to meet her self-imposed fiscal rules and, given Labour’s mantra, the former seems most likely. Nevertheless, the conference is set to end on Wednesday with Reeves keeping her options open. She is due to receive the OBR’s latest forecasts on Friday, and particular attention will be paid to growth forecasts, which could have a significant impact on the gap in public finances.

Gilt Jitters Linger

At the beginning of September, rising yields on UK government debt hit the headlines as the yield on the 30-year benchmark reached its highest level since the late ‘90s. Many saw it as a sign that the market is losing confidence in the UK government, although - as previously discussed - there were several contributing factors. Although yields have since eased back from their highs, they remain elevated by historical standards and there is clear apprehension over what’s to come.

Sterling Treads Water

Sterling has been relatively stable against the dollar over the past month (it looks set to end the month around -0.5% on a spot returns basis), however its cause has been aided by negative influences on the USD side. Against the euro, the pound is down almost 1% leaving GBP/EUR right towards the bottom of its recent range (and arguably showing signs of breaking lower).

Outlook: Cautious on the Pound

Looking forward, we continue to forecast GBP/USD higher, although our view remains predicated on the premise of a weaker dollar. Against the euro and other G7 currencies, we remain cautious about sterling’s prospects given the risks highlighted above. For now, we continue to see little reason to be bullish on the pound and note that, while positioning data suggests that the market already holds a significant short position, it is far from extreme levels that would imply a correction is imminent. As such, our forecasts for both GBP/USD and GBP/EUR remain unchanged from last month.       

Source: Bloomberg poll + Validus forecast