Investing.com - The recent surge in UK gilt yields has highlighted the fragility of sentiment towards the country’s fiscal position, said Bank of America, which remains the "Achilles' Heel" for sterling.
At 04:35 ET (09:35 GMT), GBP/USD traded 0.1% lower to 1.2299, near its lowest level since October 2023, and on course for a weekly loss of around 1%.
Whilst part of the move can be attributable to the move in global fixed income, sterling has been hit by an idiosyncratic move in GBP risk premium which is the major disrupter for the pound, particularly given light positioning, according to analysts at Bank of America, in a note dated Jan. 9.
It’s too early to tell whether the sterling selloff has ended, but the dislocation in skew and implied vol suggests that current bearishness is vulnerable to any improvement in sentiment via stronger growth data.
That said, the surge in gilt yields, if it persists, raises risks that the headroom Chancellor Reeves had against her fiscal rules in the October Budget disappears by the time the OBR produces its Spring forecasts near the year of March.
“In our view, chances of breaking or changing the fiscal rules are slim, given the government's commitment to fiscal stability,” Bank of America said. “We think it is much more likely that the government announces fiscal consolidation measures to meet the rules and restore the headroom.”
“Consolidation is possible in Spring or earlier (potentially via spending cuts) and perhaps more meaningfully in the Autumn. We think the bar for BoE to intervene in the Gilt market is high and comparison with the mini budget is overblown.”
Beyond fiscal concerns, markets seem to worry about inflation persistence, fueled further by global tariff worries, which the bank sees are warranted. However, growth weakness if it persists, would make the BoE's trade-off difficult.
“For now, we expect inflation persistence risks to dominate the BoE's thinking vs. growth concerns, keeping them on a gradual quarterly cutting path. But if we see a sustained and large growth and labor market deterioration (risks of which rise if market moves force a fiscal consolidation), the BoE would need to turn greater attention to these risks and perhaps speed up cuts.”