Sterling Plummets Against Euro and Dollar Amid Tax Concerns

The British pound has recently experienced significant declines against both the euro and the dollar, driven by looming tax increases and worries about slowing economic growth. On Wednesday, the currency hit its lowest point against the euro in more than two and a half years, prompting discussions among analysts and traders alike about the implications for the upcoming Budget 2025.

During trading on Wednesday, the pound fell to as low as $1.32 against the dollar, marking its weakest level since early August. In terms of its performance against the euro, sterling dropped to nearly €1.13, the lowest it has been since April 2023, before slightly recovering to settle at €1.14.

The depreciation of the pound can be attributed to two primary factors: the anticipated increase in taxes that will be outlined in the forthcoming budget and the recent adjustments to the UK’s productivity outlook. With Rachel Reeves tasked with addressing a larger budget deficit than previously expected, traders reacted to the news by driving down the value of sterling.

Market analysts have indicated that the expectation of tax hikes and spending cuts as part of a stringent budget on November 26 has shifted the timeline for when the Bank of England is likely to lower interest rates from the current 4% to 3.75%. Previously, many in the financial markets believed that any rate cuts would be delayed until March, but there is now a consensus that a quarter-point cut could occur as early as February.

Goldman Sachs adjusted their forecasts on Wednesday, predicting that the central bank policymakers' meeting next week may result in a quarter-point cut. Typically, lower interest rates lead to decreased currency valuations, as investors often seek better returns elsewhere in jurisdictions with higher rates.

According to analysts, Threadneedle Street is likely to conclude that inflation has peaked, especially given that the annual rate has remained steady at 3.8% for the past three months. This scenario could prompt an earlier reduction in borrowing costs.

In contrast, the Federal Reserve in the United States reduced its benchmark policy rate by a quarter-point on Wednesday, setting it within the range of 3.75% to 4%. Jerome Powell, the chairman of the Fed, aligned with the majority for this limited reduction, while Stephen Miran, a board member nominated by Donald Trump, advocated for a more aggressive half-point cut. President Biden has also suggested that steeper reductions in borrowing costs would be beneficial.

Despite these adjustments, many analysts predict that US interest rates will stabilize at a higher level than those in the UK, making dollar-denominated assets more appealing to investors.

Chris Turner, the global head of markets at ING, commented on the pound's decline, attributing it largely to the belief that Rachel Reeves will adhere to a stringent budget, potentially necessitating tax increases or deeper spending cuts than initially planned. He noted, "By holding the line on the fiscal rules, the Bank of England might have to cut rates a little earlier than had been priced by the markets."

Turner further highlighted that Reeves's firm approach has reduced the UK’s risk profile as a borrower, which in turn makes debt financing cheaper. The probability of a UK interest rate cut at the upcoming meeting has risen from 15% to 35% according to Turner’s analysis.

Importantly, the recent sell-off of the pound does not appear to stem from concerns regarding Reeves’s credibility or the existing UK fiscal deficit. Instead, the situation reflects a broader adjustment in expectations towards tighter fiscal policy coupled with a more accommodative monetary stance, which is characteristic of economic environments facing similar challenges.

The current economic climate in the UK is marked by uncertainty, as the looming tax rises and the anticipated budget cuts stir concerns about the future trajectory of economic growth. As the pound continues to struggle against both the euro and the dollar, the decisions made in the upcoming budget will be crucial in shaping the outlook for the UK economy. Investors will be watching closely to gauge how these fiscal measures will influence monetary policy and currency valuations in the months to come.