The pound fell on Tuesday as the new British finance minister's decision to reverse most of the government's "mini-budget" prompted investors to reassess the outlook for UK interest rates.

Liz Truss

Jeremy Hunt, who replaced Kwasi Kwarteng as finance minister after Prime Minister Liz Truss sacked the latter for his failed fiscal plan that sent the government bond market into a damaging tailspin, ditched most of the contents of the mini-budget and said he would raise over 30 billion in taxes.

Sterling shed 0.5% to trade around $1.1303 against the dollar and fell 0.4% versus the euro to 86.97 pence.

A second thorn in the side of sterling investors was the Bank of England's plan to start selling the vast holdings of gilts it amassed during the coronavirus crisis later this month.

The Financial Times reported on Tuesday that the BoE is likely to delay those sales - known as quantitative tightening and the opposite of quantitative easing - to maintain some stability in the gilts market, where long-dated yields briefly spiked to 5%.

The BoE said the report was "inaccurate", which nudged the pound and long-dated gilt prices lower. Long-dated yields edged higher, having staged their second-biggest daily drop on record on Monday.

"The only thing really to understand in my view is the down-move in yields basically means greater stability and the corollary of that is we're likely to see less aggressive action from the BoE in the short term or the long term," UBP global head of FX strategy Peter Kinsella said.

Kinsella noted that the swaps market now shows traders expect UK rates to peak at 5% in May next year. Previously, they had expected a peak of 5.75%.

"In a sense what's happened is 'what's good for yields is not good for sterling’, because basically what you're seeing is less interest-rate support," he said.

Hunt's plan to reverse most of the tax cuts in the mini-budget and limit a government-imposed cap on energy prices to six months eased some concern about Britain's ability to finance itself.

Yields on 30-year gilts were last up 5 basis point on the day at 4.47%, having fallen by almost half a point on Monday, the second-biggest daily drop since the full-point fall on the day the Bank of England stepped in to pin down yields on Sept. 28.

The BoE had been due to start selling off its vast pile of gilts, as part of its two-pronged approach to bringing down inflation by tightening credit conditions, along with a series of interest-rate rises.

The government's so-called "mini budget" on Sept. 23 alarmed investors to the point where a sell-off drove borrowing costs to multi-year highs. This forced pension funds in particular to sell even more gilts to cover hedging positions that had soured, which prompted the BoE to step in to stabilise the market with a series of emergency bond buy-backs.

Sterling is already one of the worst-performing major currencies against the dollar this year, partly because investors expect the Federal Reserve to raise rates more aggressively than the BoE, thereby creating an advantage for U.S. assets over those from elsewhere.

But thanks to sky-high inflation, a cost of living crisis, a slowing economy and the drag on trade from Brexit, the pound has also sunk against the euro, losing 3.3% in 2022.

"While political and BoE policy remains in flux and will determine GBP's tactical prospects, we maintain a tactical short bias as well as a longer-term bearish bias reflecting the UK's relatively poor external metrics," strategists at JP Morgan led by Marko Kolanovic said in a note.

The pound's volatility has also run at historical highs in the last month. The options market shows that one-week sterling volatility has calmed down to around 15% from a peak of closer to 30 in late September, after the government's mini-budget.

But it's still a lot choppier than its G7 peers. One-week volatility for the euro is closer to 11%, leaving sterling volatility at a 3.5 percentage point premium - double the average of the last five years, according to Refinitiv data.