Turnaround Tuesday for Pound Sterling

File image of Labour leader Keir Starmer and Shadow Chancellor of the Exchequer Rachel Reeves. Image © Keir Starmer

The British Pound has been doing a bit of a random walk this week, overturning earlier losses to be the day's top performer on Tuesday.

Sterling is recording a gain on all its G10 currency peers, aided by a swing higher in equity markets, which suggests to us the fickle global investor is in charge.

Equity markets were in the red early on Tuesday after a muted Chinese fiscal stimulus failed to materialise, with authorities doubling down on and bringing forward previously announced measures.

But U.S. equity markets look prepared to discount developments in China, looking forward to further rate cuts at the Federal Reserve, even if another bumper 50 basis point cut is now off the table.

The 'high beta' nature of the Pound to Dollar exchange rate means it is off the lows at 1.3064 at 1.31, and the Pound to Euro exchange rate has recovered from 1.1898 to 1.1937.

"The FX market seems in a confused mood... with some pockets of (unmerited) disappointment towards China but no overall "risk off" mood," says Daragh Maher, Head of Research for the Americas at HSBC.

Tuesday was supposed to be a big day for the global economy as China was to announce potentially billions in new yuan to bolster growth in the world's second-largest economy. However, authorities merely took the opportunity to recommit to previously announced packages aimed at stimulating growth, which disappointed global markets and created a risk-off sentiment.

Nevertheless, markets appear to have a 'glass half full' attitude to the developments, content with the significant monetary stimulus announced two weeks earlier. 

"Some patience is required... says Maher. "The NDRC is not the organisation that issues such announcements. A fiscal boost is more likely to be announced by a State Council Executive Committee, as it was in 2008."

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GBP and Bonds Betray Nerves Ahead of the Budget

Although the Pound is up at the time of writing, it is well off its highs and could be prone to further weakness in the coming days.

This is as UK borrowing costs come back in the headlines, having climbed sharply over recent days, "fuelled by investor concerns about the Labour government’s Budget," according to reports.

The gap between UK bond yields and those of Germany is now the widest in more than a year.

Economists fear new taxes directed at society's most productive sectors, namely wealth creators, entrepreneurs, and business owners will hit UK growth.

Research suggests that some of the tax plans could, in fact, cost the Treasury money, while business surveys reveal that Labour's plans have chilled sentiment and risked sending the economy into reverse.

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The changes are specifically aimed at unlocking investment, but markets fear it will simply go into funding the day-to-day running of the state, which would include the provision of benefits and public sector pay rises.

Typically, rising bond yields would bolster the Pound, but we are witnessing a breakdown in the relationship (see the vertical line below):

Above: GBP/EUR and two-year UK bond yield (bottom).

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This signals unease amongst investors.

The Pound and yields last diverged meaningfully when Liz Truss attempted to pass her ill-fated 'mini budget' in 2022. Mark Dowding, chief investment officer at RBC BlueBay Asset Management, says the memory of the 2022 'mini budget' is still "etched into the psyche" of gilt investors.

The budget will loom as a potential obstacle to significant GBP gains going forward.

"Appetite to cut long GBP exposure could increase into the October budget," says Nicholas Kennedy, FX Strategist at Lloyds Bank. "There is approaching event risk in the form of the new government’s first budget at the end of October. Given the uncertainties that surround that, some caution could be warranted."