GBP/USD analysis: BoE hikes needed to curb gilts' term premium
Finally unveiled, the UK government's Autumn Budget was conservative and cautious, in line with market expectations.
A fiscal consolidation of £55 billion has been announced, to be split evenly between more taxes and lower spending. From the next year until 2028, windfall taxes on oil and gas companies will increase from 25% to 35%, while the Energy Price Guarantee programme (EPS) has been revised to cut down on government spending. These two measures dominate the UK's fiscal adjustment.
But now that the threat of losing the anchor of fiscal credibility has ended, sterling investors are once again confronted with the reality of the UK economic outlook.
Inflation is expected to average 7.4% in 2023, but GDP will shrink 1.4% due to the recession. A higher and more persistent inflation rate requires the Bank of England to maintain its restrictive stance for a longer period of time. Furthermore, the longer inflation stays high, the more difficult it will be for gilts to lure buyers to these negative real yields, especially since the BoE will restart quantitative tightening in late November.
GBPUSD
has risen from 1.036 to 1.203 following the reversal of September's mini-budget, primarily due to lower gilt yields, as recovered market confidence in fiscal policy has stimulated demand for UK sovereign bonds.
Gilt yields likely bottomed out before the UK Autumn Budget, as the market had largely anticipated the fiscal consolidation, and could now resume a natural upward repricing, not in a disorderly fashion, but adequately to reflect a high inflation/high interest rate environment.
The outlook for the pound is now dependent on the Bank of England's policies.
Hawkish BoE = Neutral/bullish scenario for the pound
If the BoE turns out to be more hawkish than expected – markets are currently pricing in 60bps in December and terminal rate of 4.5% next year – it can better control inflationary expectations and pressures. In this scenario, UK interest rates will increase quicker than UK 10-year gilt yields, limiting the term premium and enhancing policy credibility. This is a favourable scenario for the pound, as it can restrict the downside and discourage speculators from shorting a currency with a high yield.
Dovish BoE = Bearish scenario for the pound
In contrast, if the BoE delivers fewer rate hikes than the market currently predicts, inflation expectations will not be restrained and long-term gilt yields would rise faster than UK interest rates, effectively placing downside pressure on the pound.
A fiscal consolidation of £55 billion has been announced, to be split evenly between more taxes and lower spending. From the next year until 2028, windfall taxes on oil and gas companies will increase from 25% to 35%, while the Energy Price Guarantee programme (EPS) has been revised to cut down on government spending. These two measures dominate the UK's fiscal adjustment.
But now that the threat of losing the anchor of fiscal credibility has ended, sterling investors are once again confronted with the reality of the UK economic outlook.
Inflation is expected to average 7.4% in 2023, but GDP will shrink 1.4% due to the recession. A higher and more persistent inflation rate requires the Bank of England to maintain its restrictive stance for a longer period of time. Furthermore, the longer inflation stays high, the more difficult it will be for gilts to lure buyers to these negative real yields, especially since the BoE will restart quantitative tightening in late November.
GBPUSD
has risen from 1.036 to 1.203 following the reversal of September's mini-budget, primarily due to lower gilt yields, as recovered market confidence in fiscal policy has stimulated demand for UK sovereign bonds. Gilt yields likely bottomed out before the UK Autumn Budget, as the market had largely anticipated the fiscal consolidation, and could now resume a natural upward repricing, not in a disorderly fashion, but adequately to reflect a high inflation/high interest rate environment.
The outlook for the pound is now dependent on the Bank of England's policies.
Hawkish BoE = Neutral/bullish scenario for the pound
If the BoE turns out to be more hawkish than expected – markets are currently pricing in 60bps in December and terminal rate of 4.5% next year – it can better control inflationary expectations and pressures. In this scenario, UK interest rates will increase quicker than UK 10-year gilt yields, limiting the term premium and enhancing policy credibility. This is a favourable scenario for the pound, as it can restrict the downside and discourage speculators from shorting a currency with a high yield.
Dovish BoE = Bearish scenario for the pound
In contrast, if the BoE delivers fewer rate hikes than the market currently predicts, inflation expectations will not be restrained and long-term gilt yields would rise faster than UK interest rates, effectively placing downside pressure on the pound.