Chancellor Rachel Reeves during a visit to Tesco in Earl’s Court, London, after inflation drops to 3.6%. Picture by Kirsty O'Connor / Treasury
Pound sterling faces the long-awaited budget, where £30BN in tax rises must be found.
The pound to euro exchange rate (GBP/EUR) is back under pressure on Monday, trading at 1.1343, having failed to break above the 21-day moving average and capitalising on Friday's 0.35% rally.
The inability to sustain its advances speaks of the soft underbelly in GBP/EUR ahead of Wednesday's budget, which is front and centre for the pound, with any mistakes committed by Chancellor Rachel Reeves likely to be punished by the market.
Under a worst-case scenario, where the Chancellor fails to credibly convince investors she has a handle on the country's debt burden, the pound-to-euro could easily drop a big figure (1%) on the day.
This would be consistent with elevated risk reversal costs on the options markets, where traders go to buy insurance against any negative currency market moves.
Should a negative market reaction transpire, follow-through selling into year-end could be anticipated, and targets of sub-1.11 would be likely.
Above: The monthly chart reveals a steady downtrend.
Economists at Goldman Sachs have crunched the numbers and say Reeves will need to raise about £30BN in new tax initiatives to meet her fiscal rule of ensuring day-to-day borrowing falls as a percentage of GDP by 2029–30.
"We expect only modest spending cuts of around £3bn, implying that around £30bn of tax increases are likely required," says James Moberly, an economist at Goldman Sachs in London.
Raising such numbers in an economy that is already straining under the highest tax burden outside of wartime is a significant challenge. There are two risks for the pound:
1) Reeves simply fails to deliver the tax cuts in a budget that is fuelled more by hope than anything and,
2) the changes she does introduce cause negative second-round effects that cause an economic recession:
Last year's tax raid on employers has caused a spike in unemployment while data from the ONS suggests emigration is rising, with credible evidence suggesting these are economically productive people looking to escape the UK's rising tax rates.
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"The Chancellor has an opportunity to deliver fiscal reform, yet we expect her to take a route of political expediency which offers short-term relief but leaves public finances exposed to yet further deterioration," says Callum McLaren-Stewart, an economist at Citi.
Because Labour have ruled out directly targeting VAT, NI and income tax, Reeves will have to tinker around the edges.
Good Odds of a Relief Rally
The downside risks are therefore elevated heading into Wednesday, but we must also consider just how negative sentiment on sterling currently is.
With investors pitted against the pound, there's certainly scope for a relief rally in the event Reeves delivers even a half-credible budget.
"The bar for a credible Budget should not be particularly high given more positive underlying fiscal dynamics than in other G10 peers," Barclays says in a research briefing released November 17," says Barclays.
Barclays notes that months of speculation about the size of the UK’s fiscal gap, the measures needed to close it and uncertainty regarding government stability have seen the pound establish a negative risk premium.
This premium is simply the gap between where the pound is currently trading and where it would be trading in normal times, according to levels in UK and international bond levels.
Currency strategists at Barclays say a convincing set of decisions on Thursday would help remove this discount, though residual political risks could "pose headwinds for a while."
In the event of a relief-style rebound, GBP/EUR would rally and target the descending channel trendline at approximately 1.14. Above here is the 100-day exponential moving average, conveniently coming in at the next big round number of 1.15.
