GBP: Budget worries push sterling lower

Sterling fell sharply across the board yesterday as markets grew increasingly nervous ahead of next month’s UK Budget. The pound dropped to its weakest level in more than two years against the euro, to a multi-month low against the US dollar, and to its lowest point on record versus the Swiss franc, excluding the 2022 mini-Budget flash crash. The trigger was a renewed wave of concern about the growing fiscal gap and the potential political fallout that could follow.

At the centre of the sell-off is the prospect of a downgrade to the UK’s productivity outlook by the Office for Budget Responsibility. Reports suggest the OBR is preparing to cut its long-term productivity growth forecast by around 0.3 percentage points, a sharper reduction than markets had anticipated. According to calculations by the Institute for Fiscal Studies, this adjustment could increase public borrowing by more than £20 billion by the 2029–30 fiscal year, deepening the government’s fiscal challenge.

Chancellor Rachel Reeves, who is already operating with only £9.9 billion of headroom under her fiscal rules, now faces the possibility of needing to find an additional £25–30 billion to meet her targets. That comes before taking into account the £5 billion cost of reversing planned welfare cuts and growing political pressure to remove the two-child benefit cap. Although Reeves hopes that stronger growth and lower borrowing costs will ease the strain, speculation is rising that income tax increases could be under consideration, which would break one of Labour’s key election pledges.

The gilt market is watching developments closely. Any indication that the Chancellor might rely too heavily on borrowing could provoke a reaction reminiscent of the turmoil following the 2022 mini-Budget. Investors remain wary of how quickly confidence can evaporate when fiscal credibility is in doubt.

For now, the pound is caught between fiscal constraints and political realities. With the OBR’s final pre-Budget forecasts due on Friday and the Budget scheduled for 26 November, volatility is expected to remain high. Sterling’s direction from here depends not only on the numbers themselves but also on how convincingly the government presents its broader fiscal narrative.

USD: The rate cut is certain, but QT is the real story

Today’s Federal Open Market Committee meeting is widely expected to deliver an interest-rate cut, but attention is shifting towards the future of Quantitative Tightening. After nearly three years of balance-sheet reduction, the Federal Reserve may now be ready to pause. Markets are watching closely to see whether the Fed announces the end of QT today or waits until December. Either way, the evidence suggests that this phase of monetary policy is drawing to a close.

Quantitative Tightening began in mid-2022 as the Fed sought to unwind the huge balance-sheet expansion that followed the pandemic. Since then, more than two trillion dollars in bonds have rolled off, draining liquidity from the system. Recently, though, signs of strain have emerged. Short-term funding rates have begun to flash warnings, with the Secured Overnight Financing Rate occasionally rising above both the Interest on Reserve Balances rate and the effective federal funds rate. This is a clear sign that reserves are becoming scarce. At the same time, banks have been making heavier use of the Fed’s Standing Repo Facility, drawing on it at levels rarely seen outside quarter-end periods since 2020.

These developments are difficult for policymakers to ignore. They raise the risk of a repeat of the 2019 episode when overnight funding markets temporarily seized up. Chair Jerome Powell recently hinted that reserves could reach “ample” levels in the months ahead, which markets took as a signal that QT’s conclusion is imminent. A large trade in SOFR futures has also caught attention, suggesting that some investors expect an imminent return of liquidity once QT ends.

The Fed’s response could be twofold. First, it may end QT to address the shortage of reserves. Second, it could lower the minimum bid rate on the Standing Repo Facility to ensure money-market rates remain aligned with the Fed’s target range. This combination would help stabilise short-term funding conditions and reaffirm the central bank’s control over market rates.

If QT does end, and particularly if the Fed signals a willingness to expand its balance sheet over time to accommodate higher structural demand for liquidity, risk assets could receive a noticeable boost. It is important to stress that this would not represent a return to Quantitative Easing but rather a technical adjustment within the Fed’s “ample reserves” framework. However, should the Fed begin temporary open-market operations or hint at early-2026 Treasury-bill purchases to maintain market stability, it would still carry significant policy weight and could have an effect similar to past liquidity interventions.

EUR: Rally pauses as fundamentals weaken

The euro has risen for five consecutive sessions against the dollar, but the rally appears to be losing steam. EUR/USD has failed to hold above its 21-day moving average, which remains on a downward slope. With the Fed expected to cut rates today and the European Central Bank likely to stand pat tomorrow, the existing policy divergence is already priced in, leaving limited room for further upside.

Recent gains in the euro have been driven less by fresh momentum and more by the absence of new negative catalysts. Since July, the currency remains down by just over one per cent against the dollar, even with the ECB maintaining its current policy stance — a sign that interest-rate support is fading.

Positioning has also become a vulnerability. Speculative long positions in the euro were near their highest levels since 2023 before the US government shutdown interrupted data from the Commodity Futures Trading Commission. Without updated positioning data, many funds may hesitate to add exposure. Valuations have also become stretched: on a real effective exchange-rate basis, the euro has now overtaken the Swiss franc to become the most expensive currency in the G10 group, trading roughly two per cent above its long-run average.

Economic fundamentals are offering little reassurance. Growth across the euro area remains subdued, with GDP expected to show another quarter of near-stagnation, while inflation continues to drift towards the ECB’s two-per-cent target. Officials have reiterated that policy is “in a good place”, suggesting limited appetite for further adjustments in either direction.

Overall, the euro’s earlier rally appears to have run its course. Crowded positioning, weaker fundamentals and diminishing rate support all point to a more cautious outlook. With global risk sentiment still fragile and trade uncertainty lingering, the balance of risks for the single currency remains tilted modestly to the downside.