The Pound Sterling (GBP) was for much of yesterday the worst performing G10 currency although it ended the day third worst as Gilt yields initially gapped lower on the open before modestly recovering in response to the early morning speech by Chancellor Reeves. A pre-budget speech like this is not usual and there appeared an intent to send a message to the voting public and the markets that tough action would be taken. The 2-year Gilt yield gapped 5bps lower initially as the rhetoric from Reeves implicitly signaled the potential for tax increases that went against promises made in the election manifesto, MUFG's FX analyst reports.

GBP is likely to continue to underperform

"There were at least two questions in which the context of the question was that manifesto promises would be broken and Reeves answered the questions without challenging the premise of the questions. So the financial markets understandably took this speech as increasing the likelihood of bigger tax hikes. In particular Reeves reference to seeking budget headroom that could 'withstand global turbulence' and the budget would build 'more resilient public finances' certainly implied a larger headroom than the GBP 10bn that existed after the budget a year ago. Given this comment a doubling of the headroom seems very plausible. Gilts likely did also perform well on Reeves stating that the focus of the budget would be to lower inflation and ease the cost of living for UK households."

"But there must also be a chance that this speech was very much about setting expectations, and possibly expectations that can then be surpassed on budget day that results in a more positive reaction in the media and the markets. Bar this speech, the other important piece of budget news yesterday was the pre-budget analysis published by the Resolution Foundation that concluded that the much-reported fiscal hole that needs filling could be a lot smaller than currently assumed. The Resolution Foundation suggests that the productivity downgrade that lifted expectations of the size of the fiscal hole could be offset by stronger wage growth and estimate a hole of GBP 14bn rather than estimates that range between GBP 25-40bn."

"If the fiscal hole is smaller than expected, it is certainly feasible that the budget could then raise enough revenues to build a larger fiscal headroom while also avoiding a breach of the key election manifesto promises. It might therefore be that the negativity related to the budget pushing Gilt yields and the pound lower could become overdone. It also highlights why the BoE is likely to hold off from cutting this week given the uncertainty related to the outcome of the budget is high and by the December BoE meeting the MPC will be able to fully assess the budget and will have two CPI and jobs reports to hand as well. In the meantime though, the pound is likely to continue to underperform on the expectations of a harsh budget. The rates market pricing implies a 30% probability of a cut tomorrow."