UK fiscal risks resurface: Burnham's new policy remains unclear, investors quietly reduce holdings of UK assets

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The UK’s new government has yet to release a comprehensive fiscal roadmap, but the market has already begun reassessing the risks of UK assets. Statements by new Prime Minister Burnham about maintaining “flexibility” in fiscal rules have sparked investor concerns about fiscal discipline, government financing, and future budget arrangements, with sentiment towards UK assets clearly cooling.

This week, the pound posted its worst single-week performance against the trade-weighted currency basket in nearly a month, and UK long-term bonds continued to be under pressure. Meanwhile, several international asset management institutions and strategists have begun downgrading the outlook for the pound or reducing their UK asset allocations, believing that the market remains overly optimistic about UK fiscal prospects and the path of interest rates.

The market generally believes that the real test will arrive in November. At that time, Chancellor John Healey will release the first autumn budget of the new government, and whether it can strike a balance between expanding policy support and maintaining fiscal discipline will determine if UK assets can regain investor confidence.

Ambiguous Fiscal Rules, Market Repricing of Risk

Burnham’s latest comments on the “flexibility” of fiscal rules have once again pushed UK fiscal prospects to the forefront of the market’s attention.

Rabobank G10 FX Strategy Chief Jane Foley stated, It’s currently unclear how much flexibility Burnham wants to allow for fiscal rules, nor is it possible to judge how the Treasury will fund a new round of policy spending, so UK bonds and the pound may face further pressure over the coming months.

Based on this judgment, Foley has lowered her target price for GBP/USD to 1.32 over the next three months, and expects GBP/EUR to drop from the current roughly 0.854 to 0.865.

RBC BlueBay Senior Portfolio Manager Kaspar Hense believes the pound is "overvalued," and the market underestimates the political difficulty of the new government producing a credible budget. CG Asset Management portfolio manager Emma Moriarty also said that the market may be near the “top” for the pound, and her team has been gradually cutting UK asset allocations recently and betting on a weaker pound.

“The Truss Moment” Remains a Lingering Shadow for the Market

Fiscal risk remains one of the most sensitive topics for UK assets.

In 2022, then Prime Minister Liz Truss launched a large-scale tax cut plan lacking sources of funding, triggering a collapse in UK government bonds, a surge in yields, and rapid depreciation of the pound. The “Truss moment” is still an important reference for investors evaluating UK fiscal policy.

Most analysts believe the current situation is significantly different from 2022, making it unlikely to repeat the market turmoil of that time. However, against a backdrop of high fiscal deficits and weak economic growth, long-term bond yields may still rise further, and increased financing costs could eventually drag down pound performance.

LBBW chief economist and head of research Moritz Kraemer said, The honeymoon period for the UK’s new government is ending quickly. Facing a huge fiscal deficit, weak economic growth, and rising demands for public spending, any chancellor will be facing tremendous challenges.

The High-Yield Advantage May Be Difficult to Support the Pound Long-term

Apart from fiscal factors, another important support for the pound is beginning to weaken.

Since the start of the year, the pound has gained about 2% against the trade-weighted currency basket, mainly benefiting from the UK’s policy rate remaining relatively high among developed economies. However, with recent weak inflation and labor market data, the market is re-evaluating the Bank of England’s policy path.

Hense and Moriarty both believe, The market is currently too optimistic in pricing in up to three interest rate hikes in the next year; once rate expectations fall, the pound will lose some of its yield advantage and face additional adjustment pressure.

State Street Markets Macro Strategy Chief Michael Metcalfe said, The recent rise in the pound is largely due to rising expectations for short-term interest rates. If weak inflation and employment data lead the market to lower rate expectations, even without new political risks, the pound could give back its prior gains.

The Autumn Budget Will Be the Market’s Real Test

The market generally believes that the real window to determine the pound’s trend will open in November.

At that time, Chancellor Healey will release the new government’s first autumn budget, systematically revealing future spending plans, financing arrangements, and fiscal targets for the first time, which will directly affect investors’ judgments on the sustainability of UK fiscal policy.

Before the budget release, Burnham has already announced several tax cuts, including lowering the commercial tax burden for bars, clubs, and live event venues. As more fiscal commitments are announced, the market’s focus will gradually shift from the policies themselves to their sources of funding. If the budget fails to adequately demonstrate fiscal discipline, UK bond yields and the pound could face a new round of repricing.

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