ING strategists Michiel Tukker and Padhraic Garvey highlight that Sterling markets remain highly sensitive to UK inflation risks, especially around near-term fiscal spending plans. They argue that any sizeable immediate spending could lift British Pound (GBP) rates more than out‑year commitments, as markets still focus on the inflation outlook and Bank of England (BoE) policy rather than sovereign risk.

Near term spending keeps GBP rates jumpy

"Inflation remains the biggest threat to gilts, but with oil coming down, Burnham might be given more leeway from markets further out in the future. This is because the political risk in GBP rates is more about the UK’s inflation outlook than sovereign risk. If Labour manages to pull off a fiscal expansion in the near term, then the prospect of reaching the inflation target of 2% could be delayed again."

"Unfortunately for Burnham, at the moment, sterling rates are still very sensitive to any inflation-inducing shocks. This might be explained by the fact that the Bank of England has not managed to return inflation to target yet. When oil moved well above $100, markets were very quick to price in a significant tightening cycle, much more so than for the ECB."

"Important to note is that a fiscal expansion while inflation is rising is treated differently by markets than during a disinflationary environment. Markets are still pricing in a terminal Bank of England rate around 4%, even above the current bank rate of 3.75%. This should change next year, however, when we expect a more disinflationary environment."

"This means that the market impact of fiscal plans, such as the currently debated defence spending, depends on the timing of the spending. Near-term spending initiatives should push rates up more than spending further out into the future."

"Sterling markets remain sensitive to inflation risks, which means any near-term fiscal spending initiatives would have a significant upward impact on GBP rates. The impact of spending further out in the future should be more muted."

(This article was created with the help of an Artificial Intelligence tool and reviewed by an editor.)