GBP/USD faces heightened downside risks, as implied market volatility and risk reversals point to expectations of sterling weakness ahead of the UK Budget, with a credible fiscal plan from Chancellor Reeves key to restoring investor confidence, notes Michael Pfister, FX analyst at Commerzbank.
Market volatility is expected ahead of the UK Budget
“Risk reversals clearly showed that most market participants have a similar view, shifting towards more risk against a weaker pound in recent weeks. We are likely to see a further shift towards higher implied volatility and more downside risk reversals on GBP/USD in the coming days. Although this shift has already occurred to some extent, last year we peaked shortly after the budget presentation. However, repeated comparisons with a Truss ring, when Liz Truss shocked the financial markets “With ill-considered plans for revenues and spending, they may be inappropriate.”
“Just because the risks from a market perspective are clearly pointing towards a weaker pound, does not mean that this will necessarily happen. During both the Truss incident and the last budget, the pound did not perform too badly. But the situation was different this year. Officials, with their numerous ideas, some of which were later cancelled, seem to have failed to convince pound investors. We believe this will continue in the coming days. In other words, the risks facing sterling are more likely to materialize this year than last year. Last year, with conditions deteriorating and “The government seems to have a convincing plan.”
“In meetings with clients, we are often asked whether most of the negative arguments have now been priced in and what a positive scenario for sterling might look like. Essentially, Reeves will need to present a convincing plan to balance the budget by the 2029-30 financial year without reigniting inflation or stifling growth. Possible starting points that could convince the market include showing fiscal headroom, avoiding tax increases that lead to inflation and implementing as few short-term tax changes as possible that only postpone problems for years coming.”
