British Pound trades lower ahead of UK budget announcement

• British Pound is under pressure in countdown to UK Autumn Forecast Statement.
• Investors will pay close attention to size of UK fiscal headroom and its credibility.
• The BoJ is expected to leave interest rates steady at 1.25% on Friday.

The British Pound (GBP) is down 0.17% at around 209.70 against the Japanese Yen (JPY) during the European trading session on Wednesday. The cross is under pressure as the British currency weakens ahead of the United Kingdom (UK) Autumn Forecast Statement.

UK budget seen as fiscally cautious with gilt reaction hinging on headroom

Economists at ABN AMRO expect newly appointed Chancellor of the Exchequer John Healey to avoid major surprises when he delivers his first Budget on Wednesday. They argue that “rising debt-servicing costs, with Gilt yields near multi-decade highs, are eroding the Chancellor’s fiscal headroom… but the UK’s high inflation means wage growth is likely to be a crucial offset, making room for a potential positive surprise.” Against this backdrop, they expect Healey “to prioritise rebuilding fiscal headroom, while balancing targeted tax rises with limited cost-of-living support.”

ABN AMRO stress that “markets will be most focused on the size and credibility of the headroom that remains after the Chancellor’s budget decisions have been accounted for.” Given the current “sensitivity in bond markets,” their base case is that Healey will “err on the upper end of credible headroom estimates of around £18-24bn, i.e. something not too far from Rachel Reeves’ last budget.” They judge that “the lower bound of a satisfactory figure for markets is probably around the £14-15bn mark,” warning that “below £14bn, the Chancellor risks a negative bond market reaction,” whereas “anything close to or above Reeves’ £24bn is likely to result in a positive market reaction.” While they note that “much of the rise in gilt yields reflects the global repricing of interest rates,” they caution that “insufficient headroom could add a UK-specific fiscal risk premium on top of this.”

Looking at the recent fiscal trajectory, ABN AMRO point out that “headroom has been perilously low in recent years as the UK came under increasing fiscal pressure, though Healey’s predecessor Rachel Reeves worked hard to rebuild it.” They recall that “up until recently, headroom was forecast to decline sharply on the back of the jump in interest rates we have seen this year, from £24bn to around £13bn.” However, they “see room for a positive surprise, and this is linked to the Office for Budget Responsibility’s (OBR) wage growth assumption,” reinforcing their expectation that Healey will aim for headroom “on the upper end of credible headroom estimates of around £18-24bn.”

Ahead of the UK budget announcement, 10-year UK Gilt yields have given back their early gains, but are still 0.18% higher to near 5.35%.

Going forward, the next major trigger for the British Pound will be the Bank of England’s (BoE) monetary policy announcement next week. The BoE is highly anticipated to hike interest rates by 25 basis points (bps) to 4%.

Meanwhile, the Japanese Yen outperforms its major currency peers, with investors awaiting the Bank of Japan’s (BoJ) monetary policy decision on Friday.

BoJ seen on hold as market prices in December hike and firmer Yen support

Analysts at Brown Brothers Harriman (BBH) note that the BoJ is "widely expected to keep rates on hold at 1.25% and assess September’s 25bps hike before tightening again." They highlight Governor Kazuo Ueda’s cautious tone, recalling that "in September, BoJ Governor Kazuo Ueda warned that rapid rate hikes could unsettle asset prices, adding that it could take some time to confirm that 2% inflation is entrenched." Despite this measured stance, BBH points out that market pricing has turned more hawkish, with "the swaps curve price in 75% odds of a 25bps BoJ rate hike to 1.50% at the December 18 meeting and nearly 75bps of tightening in the next twelve months," a shift that they see as supportive for the Yen.