Sterling faces pressure as BOE dovish tilt and budget risks cloud outlook

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Sterling faces BOE, budget risks

Highlights

Sterling's outperformance in 2024 fades as Bank of England holds rates at 3.75% and investors price in tighter policy from the ECB and Fed.
Upcoming Oct. 28 budget poses political and market risks, with investors scrutinizing government adherence to fiscal rules amid rising borrowing costs.
Potential budget measures—higher ancillary taxes, increased debt issuance, and property-related levies—could unsettle markets if viewed as growth-negative or private sector restrictive.

Rate outlook shifts against sterling

As reported by CNBC, the pound has held up through political upheaval and external shocks, but analysts now see a greater risk of further weakness as monetary policy expectations move against the UK currency.

Sterling has gained about 1.6% against the euro this year, 2.8% against the Swiss franc, 4.9% against the Swedish krona and 1% against the Canadian dollar. It is near flat against the U.S. dollar over the same period and down 1.3% against the Japanese yen.

Matthew Ryan, head of market strategy at Ebury, says sterling has been the surprise outperformer in the G10 over the past three months, helped by a more resilient UK economy. Gross domestic product grows 0.4% in the second quarter after 0.6% growth in the first quarter, while consumer spending benefits from sunny weather and FIFA World Cup-related demand, and business activity remains relatively firm.

The pound also draws support earlier this year from expectations that the Bank of England could respond to inflation risks linked to higher energy prices during the Iran conflict. But with the central bank holding its key rate at 3.75% throughout this year and market pricing showing low odds of a hike in September, that support is fading as investors expect tighter policy from the European Central Bank and increasingly from the Federal Reserve later this month.

Budget plans add political and market risk

Dovish Bank of England messaging on Sept. 17 could leave sterling more exposed just before the Oct. 28 budget, a key test for Burnham's new administration. Investors are watching whether the government maintains the fiscal rules stressed by former Finance Minister Rachel Reeves, especially after Britain changes leader again and borrowing costs rise alongside a broader global bond sell-off.

Finance Minister John Healey says he remains committed to fiscal discipline while aiming for a more even distribution of growth beyond London. JP Morgan UK economist Allan Monks says those comments point to a cautious approach to tax and spending changes given higher borrowing costs, with the budget likely to keep its focus on devolution, stronger public control of services and more private sector partnerships, while doing little to alter the broader macroeconomic outlook.

Ryan says the budget carries a high level of political risk and could include a mix of higher ancillary tax rates and increased debt issuance to fund spending plans. Possible measures include changes to property purchase taxes and local council duties, a mansion tax and tighter pension and personal investment account relief, steps that could unsettle markets if they are seen as weakening growth, squeezing the private sector and requiring more borrowing.

In our earlier coverage of UK inflation risks ahead of the October 28 Budget, we outlined how energy-market disruptions and weather-related food price pressures were raising the odds of inflation re-accelerating later this year. We also noted that higher borrowing costs and Budget uncertainty were tightening the government’s fiscal room for manoeuvre, leaving the Bank of England’s rate path more sensitive to renewed shocks.

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