Short-Term Rate Differential Is the Medium-Term Anchor for EUR/GBP
Source: ING, Refinitiv
Tight Fiscal Arithmetic Becomes Harder to Ignore
Like much of Europe, there are plenty of reasons to be downbeat about the UK’s public finances. Spending pressures are growing – from defence to health and social care. Debt interest costs are high and rising, not helped by Britain’s large stock of index-linked bonds and increasing reliance on foreign investors (particularly hedge funds).
The tax burden may be the highest in decades, but spending has risen more significantly as a share of GDP since 2019. And tax on wages – income tax and social security – is among the lowest in Europe as a share of average labour costs.
That said, the UK is also a rare example of a country undergoing some meaningful fiscal consolidation. Since 2021, the tax thresholds have been frozen in cash terms. And subsequent waves of inflation have dragged more and more people into higher tax brackets, increasing tax revenues as a share of GDP. This fiscal drag is planned to continue over the remainder of this decade. And it’s a key reason why gilt issuance is falling significantly – from £303bn in FY2025 to £246bn in the current fiscal year.
In short, there’s a more positive near-term public finance story even if longer-term, it’s hard to see how borrowing doesn’t increase over and above current budget plans.
Over recent weeks, investors had become more relaxed about Burnham’s appointment, following his commitment to stick to the existing fiscal rules. In theory, that precludes a stimulus package this autumn that would either materially increase gilt issuance or change the calculus for the BoE. But Burnham’s recent openness to bigger changes – including lifting the tax-free allowance and greater funding for social care – means a bolder budget can’t be ruled out. Investors will be particularly sensitive to any headlines on tweaks to the fiscal rules in the run-up to Burnham’s first budget this October or November.
Sterling to Hand Back Gains
Sterling’s summer rally has come as a surprise to most, but it looks to be built on weak foundations. Into the autumn, we expect UK short-dated rates will be coming lower and the UK’s fiscal position will again be under scrutiny. That means EUR/GBP doesn’t need to spend too long down at these levels near 0.85 and we remain comfortable with our call for a move to 0.88 by year-end and a push to 0.90 in 2027.
And based on our view that the Fed does not tighten in this cycle and the dollar softens, should continue to trace out a 1.32-1.36 range.
ING’s Forecasts for GBP
Source: ING
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