Sterling jumped to its highest level in two and a half years after the Bank of England's hawkish stance, but strategists warned that the upcoming UK budget could pose risks to investor and consumer sentiment.

Many investors are waiting for the new Labour government to unveil its fiscal plans at the end of October before making long-term forecasts for the UK economy and assets. Prime Minister Starmer has warned that the upcoming decision will be "painful" for the public.

Meanwhile, Labour will kick off its annual party conference on Monday, its first in power in 15 years, with its leadership seeking to move on from a recent controversy over donations and pledging to "rebuild Britain".

The Bank of England kept interest rates unchanged against the backdrop of a rate cut by the Federal Reserve last week. Both actions were expected, but the former took an unexpectedly hawkish stance, stressing the need for "gradual" easing, while the latter opted for a sharp 50 basis point cut as it stressed the need to support the US labor market.

The pound sterling/dollar exchange rate broke through 1.33 last Thursday, hitting a new high since March 2022, and was trading around the 1.33 mark on Monday.

Chris Turner, ING’s global head of markets, said in a note on Friday that the pound’s gains were tied to central bank information and “look entirely reasonable.” Traditionally, higher interest rates are good for a currency because higher yields can attract more foreign capital.

“The central bank does seem to be questioning whether inflation will fall as it has in the rest of the world... The central bank certainly isn’t signaling like the Fed has that inflation is ‘all but gone,’ ” Turner said.

The main concerns for the Bank of England remain services inflation (which rose to 5.6% in August from 5.2%) and wage growth, which also remains above an annual rate of increase of 5%.

Sterling’s gains last week extended a long-term trend, with analysts generally seeing positive results following Britain’s Labour Party election victory in July, including increased political stability and plans to reform housing policy and strengthen ties with the European Union.

But some warn that sterling’s recent gains, fuelled by interest rate differentials, could be hurt by the budget due on Oct. 30.

Jane Foley, head of FX strategist at Rabobank in London, said: "The fiscal plan could become a test for sterling bulls if tax increases erode UK investor confidence."

Increases in VAT, national insurance (a universal tax) and income tax are all ruled out, but there are likely to be other tax increases, crackdowns on the super-rich and public spending cuts. Labour has repeatedly stressed that boosting Britain's slow economic growth is its top priority.

Turner said a 1% rise in UK retail sales in August supported the pound, "but leading indicators of consumer confidence warned that consumers were starting to feel worried."

This in turn could have an impact on consumer spending and short-term growth.

Gabriella Dickens, G7 economist at AXA Investment Management, also expressed caution about the outlook for the pound in a note last Thursday. She said a 25 basis point rate cut in November would be consistent with the Bank of England continuing to move “gradually” - beyond that, the main risk remains the budget.

"If fiscal policy were to tighten more than the previous government planned, this would likely increase pressure on the central bank to accelerate the rate cut cycle," Dickens said. "Given recent signals from the new government, including reference to a £22 billion shortfall in the public finances and hints at further tax increases, we think this is likely. If the government is more stringent on fiscal policy, we think the central bank would be forced to accelerate the rate cut cycle to offset the hit to household and business finances."

Uncertain outlook

ING strategists do expect the BoE to become more confident about the trajectory of UK inflation later this year, which could lead it to accelerate rate cuts beyond the November cut that markets have already priced in.

“However, this may take some time, during which time the pound can continue to perform well,” Turner said, which could lead to a push towards the 1.35 area against the dollar.

Oliver Wyman Vice Chairman Huw van Steenis said on Friday that despite Bank of England Governor Bailey's denial that rising public sector wages are the main driver of inflation, policymakers will pay close attention to the "substantial" pay rises enacted by the Labour Party. Millions of public sector workers, including teachers and doctors, will receive above-inflation pay rises from the new Labour government in the UK. He said:

"One of the expectations of the Bank of England is that costs will remain the same next year and they are starting to get a little concerned that they will have to increase the increase more. If you read the statement that the Bank put out, it's clear that they are sticking to it and they want to emphasize and put 'gradually' in bold."

Article forwarded from: Jinshi Data