Morgan Stanley Shorts Pound Ahead of U.K. Budget

Morgan Stanley has taken a bearish stance on the British pound ahead of the U.K. budget announcement on October 28. The bank's FX strategists, led by Bruna Skarica, recommend a short position at 1.3220, with a target of 1.2850 and a stop at 1.3350. They argue that sterling prices in too little fiscal risk, suggesting the trade hedges against potential increases in GBP-negative risk premium.

The bank anticipates a "low-key" budget that slightly delays fiscal consolidation. Morgan Stanley estimates the Chancellor’s fiscal headroom has narrowed to £8 billion from £24 billion in March, primarily due to higher gilt yields. To restore headroom to £15 billion, the bank foresees £15 billion in revenue-raising measures, mostly through tax increases, and a permanent £8 billion rise in day-to-day spending.

Morgan Stanley projects the headline deficit to reach 3.7% of GDP next year, up 0.7 percentage points from March, with about 0.5 points attributed to debt-servicing costs. They expect an average £15 billion increase in cash requirements over the next three fiscal years. Major spending decisions are likely deferred until next year’s Spending Review, which would require about £11 billion to boost defense spending to 3% of GDP and another £13.5 billion to prevent real-terms cuts in unprotected departments.

Strategists highlight that risks to the budget are skewed to the downside, with less immediate consolidation or lower headroom. The most plausible upside scenario involves more aggressive action on headline inflation and year-one spending freezes. They also note the U.K. relies on foreign capital inflows, with fiscal plans under scrutiny following past surprises in borrowing. The bank’s rates strategists see mild downside risks for gilts due to delayed consolidation and higher supply.

Equity strategists believe tax risks are largely priced in for banks and view the U.K. market as sector-driven rather than influenced by domestic macro factors.