Over the past week, the UK unemployment rate came in higher than expected at 5.0%. On Thursday, Q3 GDP data showed the economy grew by just 0.1%, half of what had been forecast. That marks a sharp slowdown from the 0.3% expansion seen in the second quarter. For the market, this is almost a direct signal: at its December meeting the Bank of England is now widely expected to cut rates — especially given that the previous decision to keep them unchanged passed with only a razor-thin majority.

Why did the pound fall on Friday?

Before the London session opened on Friday, the Financial Times published a piece claiming that Chancellor Rachel Reeves had backed away from plans to raise income tax. The UK Treasury has not confirmed any of the rumours about what will be in the Autumn Budget, but two weeks earlier Reeves gave a speech that markets largely interpreted as laying the groundwork for an income tax hike.

That is why the rumour about abandoning the tax increase came as a surprise. Ironically, the reported reason was an upgrade by the ONS to its forecast for UK economic growth next year: a faster-growing economy naturally generates higher tax revenues on its own.

But markets were worried about something else — it is widely understood that there is a roughly £30 million “hole” in the public finances that has to be filled somehow. If income tax is not going up, that leaves a patchwork of adjustments to other levies and duties as the most likely option.

How does the spike in gilt yields affect the pound?

If tax revenues do not increase, the government will have to issue more debt to cover its spending. The problem is that investors are already demanding a premium to hold British bonds because of concerns over the sustainability of the UK’s public finances. At this point, gilt yields are the highest among the G7 countries.

One way for a country to reduce its debt burden is to issue more debt and, in effect, expand the money supply. But that tends to push inflation higher. Investors, worried about this, demand higher yields. If they believe inflation will outpace the return on bonds, they start selling those assets aggressively.

That is essentially what is happening now: traders are dumping pound-denominated assets at a record pace, dragging the currency lower.

The Autumn Budget and market expectations

Markets are waiting to see how Reeves intends to plug the budget gap, but there will be no concrete answers until 26 November, when the Budget is published.

For now, attention is focused on the UK CPI release due on Wednesday. If inflation continues to slow, the pound could weaken further as traders price in additional easing from the Bank of England.

If, however, inflation unexpectedly accelerates, that could undermine confidence in a December rate cut and provide temporary support for sterling.

The consensus forecast among analysts is as follows:

  • October CPI: 3.7% (versus 3.8% in September).

  • Core CPI: 3.4% (versus 3.5% a month earlier).