Analysis-UK markets head back into troubled waters as fiscal angst rises

By Linda Pasquini

(Reuters) -A string of policy U-turns has blown a hole in the UK government's budget plans, bringing sterling's stellar run against the dollar and a period of stability in UK bond markets to a halt and prompting analysts to predict more weakness ahead.

UK gilts suffered their biggest one-day selloff since April's U.S. tariff turmoil on Wednesday and sterling tumbled as speculation about finance minister Rachel Reeves stepping down added to uncertainty over the fiscal policy outlook.

It's a backdrop that suggests the best days for sterling, which had been sailing at 3-1/2-year highs against the dollar, may be in the past, even as markets stabilised on Thursday.

For UK gilts, which at one point on Wednesday saw selling on a scale that drew parallels with 2022's budget crisis in the short-lived premiership of Liz Truss, the vulnerability of bonds to fiscal unease was laid bare.

"Of all our updated forecasts this month, the one that receives the most radical surgery is our projection for sterling," said Nick Rees, head of macro research at Monex Europe. He expects sterling to weaken to $1.33 in six months from around $1.37 now.

"Underpinning this shift is a fundamental change in view on the outlook for the UK public finances."

Sterling is sitting on a roughly 9% gain against the dollar for the year so far as heightened policy uncertainty under U.S. President Donald Trump prompts global investors to diversify away from U.S. assets.

But it's down around 4% against the euro and 5% against the Swiss franc amid growing investor angst over weakening growth and fiscal uncertainty one year on from the ruling Labour party's landslide election win.

"Ultimately, (Prime Minister Keir) Starmer may be pushed into announcing a commitment to raise taxes in the Budget this autumn," said RBC BlueBay Asset Management Chief Investment Officer Mark Dowding.

Monex's Rees said he expected sterling to decline nearly 10% against the euro over the next 12 months. The euro was last trading at around 86.35 pence.

The outlook for public finances has deteriorated after Starmer gave in to pressure from within his party - and from the poll-topping Reform UK party - to soften welfare spending cuts.

A partial U-turn on tighter rules for long-term sickness and disability benefits will reduce savings by around 3 billion pounds ($4.1 billion) a year, while a decision to restore winter energy subsidies for some pensioners will cost around 1.5 billion pounds, according to think-tank estimates.

Reeves said in March she had a buffer of just under 10 billion pounds to stick within her fiscal rules and economists say further tax increases may be necessary to stay on track.

The latest selloff in gilts only adds to those pressures by increasing government borrowing costs.

Britain's 30-year bond yield, trading at 5.34%, is off Wednesday's high but still relatively elevated.

"The fear of a new chancellor ripping up Reeves' self imposed fiscal rules, has seen many of these (long gilt) positions exited," said Craig Inches, head of rates and cash at Royal London Asset Management, adding that he had seen Thursday's selloff as a gilts buying opportunity.

Starmer on Wednesday ruled out Reeves resigning.

BUILDING PRESSURE

Sterling, which fell as much as 1% on Wednesday, has benefited from broad-based dollar weakness, but trading in FX options suggests sentiment has turned.

Since April 2, the benchmark one-month sterling/dollar risk reversal has shown a premium for holding sterling call options - the right to buy at a set price and known time frame. But this position flipped sharply on Wednesday, pricing data shows..

Lloyds FX strategist Nick Kennedy said a rise in the euro towards 87.40-87.60 pence over the next couple of months seemed likely, while adding a move to 90 pence - implying a further sterling weakening - could create some breathing space for the economy from global and domestic events.

A weak currency gives exporters a competitive edge.

While the euro has benefited from a boost to long-term growth prospects as Germany in particular ramps up stimulus, the UK economic outlook has weakened, with unemployment rising to its highest in nearly four years.

Kennedy said the key difference between Germany and Britain was that while both economies are borrowing more, Germany's is aimed at boosting growth, while Britain's is because it is struggling to grow.

"And until there's a sensible debate in the UK about how to address those issues rather than pretending that they're not there, then the rationale for further euro outperformance versus sterling just holds up," Kennedy said.

Rees at Monex, said he had not seen such levels of concern over UK public finances since the "Liz Truss moment", when her premiership was derailed by a bond market selloff.

"In front of mind for traders, you are going to see that building downside pressure on the pound," he said.

($1 = 0.7297 pounds)

(Reporting by Linda Pasquini. Additional reporting by William Schomberg, Yoruk Bahceli and Alun John. Writing by Dhara Ranasinghe. Editing by Mark Potter)