Sterling under fiscal strain as markets eye UK budget risks

Sterling, which ranked as the second-best performing G10 currency last week, has slipped back at the start of this week. GBP/USD is struggling to maintain the $1.35 handle, while GBP/EUR has stalled around its 50-day moving average near €1.16 – a level not convincingly broken since mid-June.

Stronger UK GDP data had briefly eased fears of stagflation, yet with growth forecast to cool in the second half of the year and inflationary pressures proving persistent, the Bank of England’s policy path remains uncertain. That uncertainty clouds the sustainability of sterling’s recent yield-driven rally.

Compounding the pressure, thirty-year inflation-linked gilt yields have surged to their highest since 1998, exceeding levels seen during the Truss-era turmoil. Rising borrowing costs are raising questions over the UK’s fiscal sustainability, particularly with the Treasury’s cash buffer running low ahead of the autumn budget. Chancellor Reeves faces the risk of breaching her own fiscal rule unless tax rises are considered – a politically fraught step that could dent investor confidence.

Attention now turns to tomorrow’s July CPI release, expected to show headline inflation edging up to 3.7 per cent. Such an outcome would bolster expectations that the Bank of England will keep rates on hold at 4 per cent through year-end. Normally, this stance would lend support to sterling, but lingering worries over weak growth and fragile public finances may limit further upside.

Euro steady as markets await Jackson Hole

The euro has been treading water, with EUR/USD spending the past ten sessions consolidating just above $1.16 in unusually subdued conditions. Volatility has dropped to its lowest level since March, despite the looming Jackson Hole Symposium, which could act as a catalyst.

Positioning data show traders trimming bullish bets, signalling a more cautious short-term tone. With conviction fading, EUR/USD looks likely to remain range-bound into the week’s close.

Even so, the broader case for the euro remains intact. Despite summer weakness, the single currency still carries long-term appeal as an emerging reserve anchor. Europe’s policy agenda has shifted towards infrastructure and defence investment – measures that could provide medium-term growth momentum. Technically, the charts urge caution, but the macro backdrop of monetary divergence, reduced trade-war risks, and steady eurozone inflows continues to support a gradual upside bias.

US yield curve shift signals key moment for the dollar

The US Treasury market is undergoing a bear steepener, with both short- and long-dated yields rising but longer maturities climbing faster. The spread between 30-year and 2-year bonds has widened to +117 basis points – its highest in three years. This sharp reversal from the deep inversion of 2022–23 suggests markets are pivoting from recession fears towards expectations of sustained growth and sticky inflation.

Multiple forces are at play: stubborn inflation, stronger nominal growth underpinned by fiscal stimulus, rising term premia, the so-called AI boom, and heavier Treasury issuance. Historically, similar episodes – in 1994–95, 2013 and 2021 – favoured cyclical equities such as financials and value stocks, while weighing on long-duration bonds.

For the dollar, the implications are significant. The greenback has already fallen around 9 per cent year-to-date, and the steepening curve points to further weakness. Higher long-term yields reduce the relative attractiveness of US assets, while stronger global growth prospects encourage capital to flow into riskier overseas markets.

The key question is whether this bear steepener evolves into a bull steepener – a scenario where short-end yields fall faster, typically driven by Federal Reserve rate cuts in response to softer economic conditions. If US labour markets weaken meaningfully and core inflation retreats, the Fed could be forced into a more aggressive cutting cycle, accelerating dollar downside.

For now, however, a September cut appears unlikely. Despite dovish remarks from some policymakers, two dissenting votes at the July FOMC meeting, and softer payroll data, Jerome Powell is unlikely to shift course substantially while unemployment and inflation remain firm. Mixed signals from July’s CPI and PPI – cooling in some tariff-sensitive goods but persistent service-sector pressures – only reinforce the Fed’s caution.

In short, the yield curve’s three-year high reflects market scepticism over a smooth disinflationary path. Powell’s focus on prioritising inflation over growth suggests a later, shallower easing cycle – consistent with the ongoing bear steepener. The dollar’s trajectory will remain closely tied to whether this steepening trend endures or the economy weakens enough to force a decisive policy shift.

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