GBP made gains against the USD, surpassing the $1.27 mark and reclaiming a position above €1.17 against the EUR yesterday. This upward movement seemed to be a result of the selling spree of the USD following the ISM report. Today, attention is focused on the UK Budget, and if moderate tax cuts contribute to a steady increase in UK gilt yields, the pound could experience an upward jolt.

UK Chancellor Jeremy Hunt faces a delicate balancing act in determining the scope of fiscal measures, given the challenges of a persistent inflation outlook and lack-luster growth forecasts in the UK economy. The government's net borrowing position remains a key consideration, requiring a careful balance between economic recovery efforts and fiscal responsibility. The challenge lies in supporting public services, stimulating economic growth, managing the national debt, and responding to external economic pressures.

With the UK economy having entered a recession in the final quarter of 2023 and the market adjusting expectations for Bank of England (BoE) rate cuts, Chancellor Hunt's fiscal flexibility is limited. The possibility of significant tax cuts ahead of a potential 2024 election may be less likely. The market's repricing of BoE rate cuts has led to higher borrowing rates in recent weeks, constraining Hunt's fiscal options. The reduced scope for tax cuts could increase expectations of early BoE rate cuts, putting pressure on the sterling.

On the other hand, an excessively large and unfunded fiscal stimulus could heighten concerns about persistent inflation, potentially causing turmoil in gilt yields and weighing on the pound. A moderately-sized tax relief package that avoids triggering gilt market disruptions might offer some support to the sterling, possibly pushing GBP/USD closer to its 2024 peaks around $1.28. While the UK gilt market experienced a significant downturn 18 months ago, a similar level of turbulence is not anticipated today. Nevertheless, surprises are always possible in the financial markets, and traders should remain vigilant.

UK retail sales experienced a modest 1% increase on a like-for-like basis compared to the previous year, showing a slowdown from January's 1.4% gain and falling short of the anticipated 1.5% growth. This subdued performance was attributed to adverse weather conditions and persistent cost-of-living pressures, resulting in the lowest figure since August 2022. The GBP/USD exchange rate retreated from the $1.27 level in anticipation of a significant week of data and events that had the potential to impact the markets.

Amidst stability in financial markets, investors have been willing to embrace higher risks in pursuit of greater returns. Equities have been consistently reaching record highs, and Bitcoin has surged by 60% in just a month. Despite the attractiveness of the higher-yielding pound, reflected in a net increase of $3.7 billion in bets on GBP, the GBP/USD spot rate has displayed a narrow sideways movement since the beginning of the year, trailing behind global equity indices.

While the pound has only marginally benefited from the prevailing low volatility and risk appetite, the implied volatility of GBP/USD has reached levels not seen since early 2020, before the pandemic. GBP/EUR implied volatility, on the other hand, has hit 17-year lows. With expectations that the Bank of England (BoE) will implement fewer rate cuts compared to its counterparts in the coming years, the pound maintains an attractive yield profile relative to other currencies. However, the excessive long GBP positions may constrain its upside potential.

The market sentiment is subject to rapid changes, and potential tax cuts announced by the UK Chancellor tomorrow could exert upward pressure on yields, already near 15-year highs. This may provide added motivation for the BoE to prolong its decision to hold interest rates, a move that could prove beneficial for the sterling.

Despite the looming UK Spring Budget this Wednesday, market sentiment remains calm in anticipation of the event. This tranquillity contrasts sharply with the conditions during the Liz Truss fiasco in October 2022, where implied volatility soared to levels comparable to the Brexit vote and Covid shock. This led to a historical disconnect with UK gilt yields surging and the pound plummeting, reaching a record low below $1.05 in GBP/USD. Since then, GBP has experienced fluctuations, recovering above $1.30 in July 2023, dropping to $1.20 in October 2023, and stabilizing between $1.25 and $1.28 over the past three months. This period of relative calm is unusual but lends support to GBP due to its high-yield appeal in carry trades. The question now is whether the upcoming UK fiscal event will disrupt this stability. While fiscal events typically don't heavily impact FX markets, the prospect of a UK election may prompt the Chancellor to unveil a significant package of tax cuts, despite constraints from increasingly tight fiscal forecasts.

UK Chancellor Jeremy Hunt has cautioned that there is a "long path" ahead to reduce Britain's tax burden, currently at its highest in 70 years. Yet, potential fresh tax cuts could exert upward pressure on yields, which are already near 15-year highs. Substantial cuts to income tax would provide additional motivation for the Bank of England to maintain interest rates at their current levels for an extended period.

The EUR staged a late recovery at the beginning of the new month, gaining momentum as a hotter-than-expected inflation print for the Eurozone boosted the common currency against the USD in the final stretch of the week. The yield on the 10-year German government bund retreated toward the 2.4% mark, down from the three-month high of 2.50% on February 29, as investors considered the subsequent monetary policy implications ahead of the ECB rate decision this week.

On a weekly basis, EUR/USD remained largely unchanged, registering only a marginal 0.1% week-on-week gain to close above the $1.0830 mark. Mid-last week, the pair entered a slight bearish streak, suggesting that further downside for EUR/USD cannot be ruled out. A breach below $1.0800 could attract EUR sellers, potentially paving the way for an extended slide toward $1.0760. Conversely, signs of a slowdown in the US economy or labour market could see EUR/USD testing $1.0870 before confronting the psychological barrier of $1.0900.

The much-anticipated US inflation report released yesterday failed to disrupt the prevailing market inertia. GBP/USD experienced a modest 0.4% fluctuation but closed the day lower, remaining within its 3-month trading range. Despite historically low realized volatility, the implied volatility in GBP crosses is currently at multi-year lows, indicating a lack of anticipation for increased market activity in the near future.

With the upcoming UK Spring Budget next Tuesday, market sentiments remain calm in contrast to the turmoil witnessed during the Liz Truss fiasco in October 2022. During that episode, implied volatility soared to levels comparable to those seen during the Brexit vote and the Covid shock, leading GBP/USD to hit a record low below $1.05. Subsequently, the pound experienced a recovery to over $1.30 (July 2023), a fall to $1.20 (October 2023), and has since stabilized within the $1.25-$1.28 range over the past three months. While this period of tranquility is atypical, it reinforces the GBP's appeal in high-yield carry trades.

As the UK fiscal event approaches next week, the prevailing question is whether it will disrupt the current stability. Usually, the GBP reacts minimally to such events; however, considering an impending UK election, the Chancellor might unveil a relatively substantial package of tax cuts despite the constraints posed by increasingly tight fiscal forecasts.

The EUR maintained its position above the $1.08 threshold as downward pressure on the US dollar from US PCE price figures and lower-than-expected German inflation data created an opportunity for the European Central Bank (ECB) to consider interest rate cuts starting in June.

Initial CPI reports from major European economies revealed a decline in Germany's inflation rate to 2.5% in February, below the market's anticipation of 2.6% and hitting the lowest level since mid-2021. Simultaneously, France experienced a decrease in its inflation rate to 2.9%, marking the lowest level since January 2022, while Spain recorded a six-month low of 2.8%, slightly surpassing market expectations of 2.7%. Despite recent positive inflation surprises, the ECB remains cautious, warning against premature declarations of victory over inflation.

ECB President Lagarde stressed on Monday the importance of additional evidence confirming that price growth is moving towards their target before considering monetary policy adjustments. Some Governing Council members are awaiting clearer wage growth data before endorsing a policy rate cut. Nevertheless, investors have revised upward their expectations for an ECB rate cut in June, with the probability rising to 79%, up from 73% at the beginning of the week. Overall, money markets anticipate a cumulative 91bps rate cut by year-end.