As the UK's new government prepares to unveil its first budget in a month, traders are ramping up bets against the pound.
Industry data shows that this month, two-thirds of sterling option trading volume consisted of positions betting that the pound would fall against the dollar in the week following the budget announcement on 28 October. According to data from the Depository Trust & Clearing Corporation (DTCC), this proportion reached three-quarters of sterling-euro option trading volume.
Investors are concerned about the UK's fiscal position and how new Chancellor of the Exchequer John Healey will balance the books. As one-month options began to cover the budget announcement date, implied sterling volatility rose to its highest level since July, indicating that the cost for the market to hedge against this event is increasing.
"We believe that ahead of the October budget, the risk is skewed toward investors pricing in a further negative risk premium for sterling," said Morgan Stanley foreign exchange strategists led by David Adams.
Morgan Stanley sharply lowered its sterling forecasts, expecting the pound to fall to 1.30 dollars against the dollar by year-end and further to 1.27 dollars by mid-2027.
Amid the US-Iran conflict and renewed dollar demand driven by Federal Reserve rate hikes, sterling is already under pressure, having fallen more than 2% this month, marking its worst monthly performance in nearly a year.
As a gauge of market positioning, risk reversals also show that investors are betting on sterling weakness. UK gilts have also been highly volatile this month due to fiscal concerns.
As the Middle East conflict pushes up UK borrowing costs, Healey will strive to repair the public finances. Gilts fell on Monday, while sterling was broadly stable around 1.3255 dollars.
Roberto Cobo Garcia, head of G-10 foreign exchange strategy at BBVA, said a credible budget that preserves fiscal policy room could help curb volatility in sterling and gilts, but any fiscal consolidation measures could come at the expense of economic growth.
"We believe there is limited room for a positive surprise from the budget," Cobo Garcia said.