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The announcement of the UK Autumn Budget on Wednesday could have profound effects on the pound. The much-anticipated event has the potential to spark a financial crisis in the UK, leaving many traders in risk-off mode. But that also means that if Chancellor Rachel Reeves manages to thread the needle, there could be a substantial relief rally in UK assets.

The pound has been facing substantial headwinds over the last month. The BOE has shown it is inclined towards dovishness with its narrow vote earlier this month to hold rates unchanged. Since then, labour market and economic data have underperformed, increasing expectations of easing. On top of that, the risks associated with the Budget have led traders to sell British assets, further weighing on cable. All of this points to substantial downside risk for the pound, while a surprise could also imply significant upside potential.
 

How Could the Autumn Budget Affect the Pound?

While there is a lot of nuance to be expected in a government financing bill, the effects on the market can be categorized into three broad scenarios. The first is considered more likely: that the Budget will include substantial tax increases to cover a £20 to £40 billion shortfall projected for next year. The issue here is that last year’s budget also included tax increases, and economists generally blame them for the current slow economic growth and high inflation situation.

An increase in taxes implies a rise in the cost of doing business, reducing growth. Typically, that cost is passed on to consumers through higher prices, thereby raising inflation. The accelerating CPI would make it hard for the BOE to cut interest rates, further weighing on the economy. Initially, however, the prospect of higher rates could give the pound some support.
 

Why Would the Pound Fall if Taxes Aren’t Increased?

The second market-related concern is that Reeves doesn’t raise taxes enough. This could be in the form of a patchwork of smaller tax hikes that analysts judge won’t raise enough revenue to cover the shortfall. In that case, the government would have to increase its borrowing.

The problem is, the UK already has a historic high level of debt, fueled by pandemic-era spending and anemic economic growth. This means that markets will demand higher interest rates when lending to the government, thereby raising gilt yields (gilts are the name for UK bonds). When yields rise, the value of the gilts goes down. UK financial institutions hold large amounts of gilts, and would lose a lot of money if gilts rise too much, too fast. In fact, this could cause a significant financial crisis in Britain. This was the genesis of the “mini-budget” fiasco under Liz Truss a few years ago. Some analysts believe Downing Street has been leaking some details of the Autumn Budget to calm markets ahead of the announcement.
 

How Could the Autumn Budget Support the Pound?

The third option is that Reeves manages to raise taxes enough to plug the fiscal hole without increasing taxes so much that it threatens to slow the economy or raise inflation substantially. It’s a bit of a thread-the-needle situation, and markets might wobble a bit before becoming convinced this has been achieved.

In that case, lifting the uncertainty around what will be in the budget could be the catalyst for a relief rally. Avoiding an economic crisis could mean traders return to buying UK assets, necessitating buying pounds. It could also contribute to a slower easing cycle for the BOE. Combined, this could provide support for the pound in the medium term.

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