Brave Dip Buyers Arrest Pound Sterling's Fall Against Euro and Dollar

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The British Pound could fall further in the near term, but if you don't believe a full-blown financial crisis is imminent, buy some cheap pounds.

With 2024's second-best performer looking a great deal cheaper at 2025, some traders are buying into the British Pound's dip.

"The pound has got off to a miserable start in 2025, but as the crescendo of gloom-laden news reaches a peak, we have seen some tentative buying of the pound. Markets look to be assuming some kind of fresh fiscal consolidation will be needed to help restore the UK's position. Comparisons with 2022 are overblown but are unlikely to disappear in the short-term," says Chris Beauchamp, Chief Market Analyst at IG.

To be sure, the Pound remains vulnerable and it is too soon to say the bottom is in. However, analysts aren't yet convinced a full-blown crisis is at hand, which can offer opportunities for the brave.

"The similarity between what has gone into folklore as the 'Truss Crisis' and the current situation is that sterling and gilt yields have moved sharply in opposite directions. The extent of the move is much smaller and will probably last even less time than it did in 2022," says Kit Juckes, Head of FX Research at Société Générale.

The Pound to Dollar exchange rate (GBP/USD) slumped to a one-year low at 1.2237 on Thursday amidst a renewed selloff of UK government bonds, amidst fears the UK economy would not be able to generate the growth required to cover its bloated debt.

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The selloff eased as buyers stepped in, and GBP/USD recovered to 1.2275 ahead of the weekend.

The Pound to Euro exchange rate looks better insulated from the stresses and the losses were confined to the November low at 1.1898 before it recovered to 1.1935.

"We would also look to fade the EUR/GBP bounce (GBP/EUR drop) as immediate Eurozone macro challenges, including tariff-related concerns, remain substantive," says Jeremy Stretch, Chief International Strategist at CIBC Capital Markets.

"If we are correct in anticipating relative macro resilience into the start of 2025 this supports a bias to fade current Gilt selling interest given our bias for 10-year yields to be trading back towards 4.45-50% prior to quarter end. Any such correction also supports buying the GBP dip," he adds.

Above: Bond yields steadied at multi-decade highs on Thursday.

During the Truss mini-budget episode, GBP/USD dropped from 1.16 to 1.05. This was fully reversed by the end of October and so was the spike in gilt yields.

However, back then, the budget never saw the light of day, and Truss promptly replaced her chancellor, Kwasi Kwarteng, to steady the proverbial ship. This allowed bond markets and the Pound to recover.

It confirms political action prompts market reactions, and the question remains whether Reeves will deliver the changes markets want to see.

"What has happened this time, is that the increase in employers’ national insurance contributions announced at the Budget appears to have put the brakes on growth to a greater extent than (I, for one) expected. Deteriorating public finances may force unhelpful fiscal tightening sooner than expected," explains Juckes.

Above: GBP/USD is under pressure.

GDP data shows the economy was recording the strongest growth in the G7 in the first half of 2024, but by the end of the year this had all but evaporated, with economists expecting a flat 0% reading for the final quarter.

This would undershoot the Office for Budget Responsibility's forecasts. This means it will have to lower its 2025 growth forecasts as well as the amount of taxes the government is expected to receive.

The rising cost of debt meanwhile means the government has to find more money to pay its creditors, which will strain the finances, raising doubts about the sustainability of the UK's debt trajectory.

"Fiscal issues are weighing on the pound. Signs of fiscal de-anchoring occur when yields rise, but a currency falls, thus events on Wednesday do not bode well for the pound in the medium term," says Kathleen Brooks, research director at XTB.

Helping the British Pound and gilts recover on Thursday was Darren Jones, Chancellor Rachel Reeves' deputy, who was called to Parliament by Conservative MP Mel Stride and asked to give an urgent statement on the selloff in UK asset markets.

Jones told lawmakers that the bond market is functioning in an "orderly way" and said, "there should be no doubt of the government's commitment to economic stability and sound public finances. This is why meeting the fiscal rules is non-negotiable."

Late on Wednesday, the UK Treasury said the government was fully committed to its fiscal rules and that it would cut spending if needed in order to stabilise the financial outlook.

Economists and market participants say cutting spending is the only credible option, as raising taxes would surely damage economic growth.

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"What can Rachel Reeves do to get out of the fiscal swamp the UK is currently in? This is my tuppence worth: cut welfare budget at the same time as cutting lower rate of tax, make work pay, get people to reconsider benefits over work, and boost productivity," says Brooks.

The UK ten-year government yield, which is the benchmark most market analysts are watching, spiked to its highest level since the millennium on Thursday, reaching 4.925%.

Bond yields rise as the value of the bond itself falls, signifying investors were offloading UK debt. The budget announced by Rachel Reeves in October contained a number of measures that would significantly raise taxes on businesses, the very engines of economic growth the chancellor will rely on to generate more taxes.

We have heard that the hospitality industry has been particularly impacted, with some warning that the Reeves tax hikes will force more closures than the Covid pandemic.

Yet, higher bond yields also offer an attractive return to investors looking for a long-term and safe bet. Indeed, the question of a debt default is still not seriously being considered by investors and analysts. This week's government bond auctions show demand is still healthy with healthy cover ratios.

Rather, worries about inflation rising again - which would dent your investment in bonds over a long period - are the key reason demand might be challenged.

"History shows that discretionary investors do, unsurprisingly, respond to valuation changes so demand ought to emerge as yields rise, despite the challenging supply outlook," says Sam Hill, Head of Market Insights at Lloyds Bank.

"Nevertheless, given the scars of the mini-budget crisis, there is the risk of pockets of fragile market sentiment. As such, there is a case for the Chancellor getting in front of this and outlining plans for restoring headroom," adds Hill.

Looking at FX market action, CIBC's Jeremy Stretch says the immediate GBP retreat looks to be "broadly overdone" and that an improvement in consumer activity in early 2025 will bolster the economy.

"Although some UK retailers continue to bemoan the pace of consumer spending the latest BRC retail sales monitor detailed a strong rebound in December total sales; the uptick was led in particular by non-food/discretionary spending. Annual total sales registered the strongest monthly uptick since January 2022, suggesting positive consumption dynamics into the end of Q4," he notes.

All eyes now turn to next week's top-line UK economic data, including the release of retail sales data on Friday.