Pound Sterling To Find "Fiscal Tailwinds" from Budget

Above: Chancellor Jeremy Hunt prepares for the Spring Budget 2024 in his office at No 11 Downing Street. Picture by Kirsty O'Connor/HM Treasury.

The Spring Budget could be the trigger for further "cyclical outperformance" in the British Pound says Bank of America.

In a research note released ahead of the midweek event, Kamal Sharma, FX Strategist at Bank of America, says a new fiscal stimulus from Chancellor Jeremy Hunt could add further upward pressure to UK rates.

The "UK rates" referred to here are effectively UK bond yields, which tend to rise when markets anticipate any stimulatory impulses in the economy. Rising yields in turn help drive demand for the Pound.

"We think that the Spring Budget could be the trigger for further cyclical outperformance in GBP," says Sharma.

Budget events are traditionally low-risk events for financial markets, however, the Liz Truss budget of 2022 serves as a stark reminder of how badly such events can go when mishandled. (Read, The Pound "Shouldn't be Haunted by the Ghosts of 2022" Says Deutsche Bank).

Karma says the start of the year saw some market concern about whether the March Budget could precipitate a market response similar to September 2022, when the UK Government stretched public finances to cut taxes ahead of the general election.

However, the Office for Budget Responsibility will give Hunt some room to enact tax cuts, estimated at about £13BN, thanks largely to lower debt interest payments. Reports suggest the day's headline will be a 2p cut to National Insurance contributions, which will cost approximately £10BN.

"The fiscal headspace has assuaged these concerns and with the rates market recalibrating the timing of the first BoE rate cut, fiscal stimulus could add further upward pressure to UK rates," explains Sharma.

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"As in September 2022, GBP is likely to take its cue from the reaction in rates market but on the assumption that UK yields rise for the right reasons rather than the wrong ones, this should be supportive for GBP in a market where carry remains a major driver for FX and against the backdrop of a weak volatility environment," he adds.

In 2022, UK bond yields rose as markets dumped UK bonds, and instead of rising, the Pound tanked. This breakdown in correlation between bond yields and the Pound was symptomatic of market panic.

Now, if bond yields rise, analysts expect the Pound to follow suit.

"Markets remain relaxed that there will not be a "fiscal mistake". At the time of writing, both GBP/USD and EUR/USD 1wk implied volatility remains well anchored towards the lows for the year," says Sharma.

Bank of America has recently turned constructive on the British Pound, saying rising real incomes and full employment will support the GBP. This raises further questions over the timing of the first UK rate cut.