GBP/USD Is Entering a Zone of Depreciation Risk

Sterling trades cautiously higher as investors anticipate a fiscal tightening package in Wednesday’s U.K. budget that could reduce inflation and reinforce expectations for Bank of England rate cuts. The FX market is poised to react sharply, with the pound vulnerable if fiscal credibility is questioned or if rate-cut conviction fails to build. Gilts, particularly at the front end, will be most sensitive as fiscal policy intersects with monetary expectations.

Main Narrative

The upcoming budget has become a key macro catalyst for sterling because it directly shapes both inflation expectations and the degree of fiscal risk embedded in U.K. assets. A tightening fiscal stance, featuring restrained spending and credible deficit control, would support disinflation and reinforce the view that inflation will continue to fall through early 2026. That, in turn, strengthens the monetary policy argument for earlier Bank of England rate cuts. Lower inflation would reduce the need for restrictive real rates, making dovish pricing more justified.

However, fiscal tightening introduces a parallel effect. It can drain some of the risk premium embedded in gilts, reducing yields on the medium part of the curve as fiscal sustainability improves. While that supports debt markets, it deprives sterling of its carry attractiveness, narrowing the interest-rate differential against the US dollar and the euro. Investors will therefore weigh whether lower inflation and stronger policy credibility outweigh weaker rate support.

Conversely, a budget that fails to present a credible medium-term fiscal path risks reviving concerns about U.K. fiscal discipline. Gilt yields could rise in such a scenario, not because of stronger growth, but due to higher risk compensation. In that case, sterling would likely weaken as international investors reduce exposure to U.K. assets. This remains a tail-risk scenario, but it is relevant given persistent sensitivity to fiscal credibility since the 2022 gilt market turmoil.

Targeted Market Impact

Sterling currently trades at $1.3182 and 0.8777 against the euro. The FX market is pricing a relatively balanced set of expectations, with modest upward moves suggesting cautious optimism. A credible budget that supports disinflation would likely reduce two-year gilt yields and strengthen expectations for rate cuts in the first half of 2026. That would weigh on sterling in the near term, particularly against currencies with more resilient rate profiles such as the US dollar.

If markets believe the Bank of England will cut rates without a corresponding increase in fiscal risk, sterling could see limited downside. However, if the budget convinces investors that rate cuts are less likely despite fiscal discipline, sterling could also drift lower as interest-rate differentials weaken without compensating fiscal support. The euro-sterling pair would be especially responsive, as ECB easing expectations are less pronounced than those for the BOE.

Forward View

In the near term, the immediate drivers will be Wednesday’s budget, the BOE’s Monetary Policy Report in December, and upcoming inflation data that will confirm whether disinflation is broadening beyond energy and goods. The base-case scenario is a modestly weaker sterling as markets price fiscal credibility but also bring forward rate-cut expectations to mid-2026. Under this path, two-year gilt yields soften and GBP/USD gradually retraces towards $1.30.

The alternative scenario carries more risk. If the budget is perceived as insufficiently disciplined, markets could widen fiscal spreads on gilts and recalibrate the risk premium on U.K. assets. Under that condition, sterling could decline faster, particularly against the euro, as EURGBP tests 0.89.

Conclusion

For investors, the tactical positioning lies in closely monitoring how the budget shifts rate-cut expectations versus fiscal-risk premium. A credible fiscal package with clear disinflation signals would favor holding gilts and cautiously reducing long sterling exposure. The key risk to this view would be a budget strong enough to curb inflation but weak in fiscal credibility, creating an unstable mix of softer growth, rising yield spreads, and downward pressure on the pound.