Sterling faces 'asymmetric' risks ahead of UK budget, 'a disappointing one'

Markets so far appear unruffled as we head into budget day. Sterling has admittedly sold off sharply versus the dollar in recent weeks, though we see this as almost entirely a dollar story - the GBP/EUR pair is actually trading at 16-month highs. Options markets are pricing moderately higher volatility around the event, with one-month implied volatility in the pound rising to four-month highs (6.77%) as the tenor began to span the budget.

Options positioning turned slightly more bearish towards the pound in late-September, with one-month 25-delta risk reversal moving lower, though moves generally have been modest, supporting our call that risks to GBP are underpriced going into 28th October.

We see risks to the pound from Britain's fiscal outlook as skewed to the downside. Our concern is the fiscal quagmire described earlier: a repeated political choice to plug gaps in the public finances with tax rises and heavier gilt issuance, rather than spending restraint.

This weighs on already weak growth and leaves a larger shortfall to fill down the road. It is not a mechanical doom loop in the strictest sense, since it remains a choice, but nor do we see it as a sustainable path, and the longer it continues the more exposed sterling becomes to every wobble in the gilt market.

Our call for the budget is that Healey unveils tax rises of roughly £10bn, with risks skewed higher if the OBR downgrades its forecasts, enough to rebuild a reasonable buffer and fund modest spending increases. We expect this to come through a broad package of targeted measures, with the burden falling on capital, in particular capital gains tax and banks.

We see this as a risk given its potential to deter investment and weaken growth. We also do not expect any welfare restraint, so the budget is unlikely to dispel concerns over a perpetual cycle of tax rises, a bearish signal for the pound and gilts. Finally, the lack of leaks so far appears to be by design, and with positioning going into the event light, volatility could be amplified on the day.

The risks going into this month’s budget are also asymmetric. A good budget is largely priced in, while a disappointing one that amplifies fears over fiscal sustainability would hit gilts and the pound together. We are not, however, bracing for another Liz Truss-style blowout in gilts or a flash crash in sterling, as policymakers have clearly learned the lessons of that episode.

So far, at least, most of the pressure on gilts has also been driven by global factors - gilt yields have risen by less than Treasury yields since the spring. That could change if Healey strays from fiscal restraint and turns to measures that raise the risk of crowding out. In short, we expect a budget that is credible enough to avoid a Truss-style episode, but not so reassuring that sterling can prosper.