The pound dropped early on Friday but recovered slightly towards the end of the session due to dollar weakness. It was the culmination of a week of negative data for sterling, and comes ahead of crucial CPI data to be released this week. Markets are nervous ahead of the Autumn Budget, so even rumors have had a significant effect on the pound.
Over the last week, the unemployment rate in the UK was reported to be higher than expected at 5.0%. Then last Thursday, Q3 GDP was reported at 0.1% growth, half of what had been expected. That was a significant deceleration from the 0.3% in the second quarter. This was seen as all but confirming that the BOE will cut rates when it meets next in December, after a razor-thin vote at the last meeting to keep rates unchanged.
Why Did the Pound Drop on Friday?
Before the London market opened on Friday, the Financial Times published a report suggesting that Chancellor Rachel Reeves had done a U-turn on an expected income tax rate hike. The UK Treasury has not confirmed any rumors about what might be in the Autumn Budget. But, two weeks ago, Reeves had given a speech that the market widely interpreted as laying the groundwork for an income tax increase.
So, the rumor that taxes wouldn’t be increased came as a surprise to the market. Somewhat ironically, it was said that Reeves’ decision was based on the ONS increasing its economic growth outlook for the UK next year. A faster-growing economy means that the government’s tax revenue naturally increases. But, markets were concerned because it’s understood that the public finances have a £30 million gap that needs to be filled somehow. There is speculation that, without raising income taxes, the government will turn to a patchwork of adjustments to other taxes to increase revenue.
How Does the Spike in Gilts Affect the Pound?
Without increased revenue from taxes, the government might have to issue more debt to cover its expenditures. This is a problem for bondholders, who are already charging a premium to lend money to the British government due to concerns that it may struggle to pay its debt. In fact, gilt yields are the highest of the G7 countries.
One way a country can reduce excessive debt is to increase the monetary supply through increased debt. This has the side effect of raising inflation. Investors demand higher interest rates to compensate for the risk of higher inflation. If investors believe inflation will exceed the interest rate, they will sell those assets. In this case, traders are selling pound-denominated holdings at a record rate, pulling down the relative price of sterling.
The Budget and Data Outlook
Markets are seeking clarification on how the Chancellor will address the funding issue, but this information will not be available until the budget is published on November 26. In the meantime, traders can look to the release of UK CPI figures on Wednesday. If inflation continues to fall as expected, then the pound could weaken as traders anticipate further easing from the BOE.
On the other hand, if inflation rises above the prior month’s level, it could shake confidence in the December cut and momentarily support sterling. The consensus among analysts is that the UK October CPI will come in at 3.7%, down from 3.8% in September. The more closely followed core rate is expected to be 3.4%, down from 3.5% a month earlier.