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The threat of higher taxes in next month’s budget and concerns about slowing economic growth pushed the pound to its lowest level against the euro in more than two and a half years on Wednesday.

Sterling also slumped against the dollar as traders digested news that Rachel Reeves will need to fill a larger hole in the public finances when she puts together her budget plan, after a bigger-than-expected downgrade to the UK’s productivity outlook.

The pound fell to $1.32 against the dollar, hitting the lowest level since early August. The UK currency fared even worse against the euro, slumping to almost €1.13, the lowest level since April 2023.

Analysts said the prospect of tax rises and spending cuts as part of a tough budget on 26 November had brought forward the likely date for when the Bank of England will cut interest rates from the current 4% to 3.75%.

Until recently, financial markets had bet that the next rate reduction would be delayed until March, but investors are now fully pricing in a quarter-point cut in February.

Analysts at Goldman Sachs changed their forecast on Wednesday, saying they expected a quarter-point cut to be brought forward to next week’s meeting of central bank policymakers.

Lower rates push down currency valuations because investors move their capital out of a jurisdiction to invest somewhere else with higher rates in the hope of better returns.

Threadneedle Street is expected to view inflation as having peaked after the official annual rate remained at 3.8% for the past three months, prompting an earlier cut to the cost of borrowing.

In the US, the Federal Reserve reduced its benchmark policy rate by a quarter point to the 3.75%-4% range on Wednesday after the conclusion of a two-day meeting.

Jerome Powell, the Fed boss, voted with the majority for a more limited reduction than the Fed board member Stephen Miran – a Donald Trump nominee – who dissented in favour of a larger, half-point cut.

The US president has called for steeper cuts in borrowing costs but over the longer term most analysts estimate that US interest rates will settle at a higher level than the UK’s, making dollar assets more attractive.

Chris Turner, global head of markets at ING, said: “It looks like the fall in sterling is largely driven by the view that Reeves will hold the line on the budget – perhaps be forced to raise taxes or cut spending a little more than she’d been planning.

“But by holding the line on the fiscal rules, the BoE might have to cut rates a little earlier than had been priced by the markets.”

He said Reeves’s tough stance had also lowered the UK’s risk as a borrower, making its debt financing cheaper.

The likelihood of a cut in UK interest rates at a meeting next week has risen from 15% to 35%, said Turner.

“So the sterling sell-off is not about Reeves credibility or the UK fiscal hole, but more the adjustment towards tighter fiscal and looser monetary policy – which is typically negative for a currency,” he added.

Ipek Ozkardeskaya, a senior analyst at the currency dealer Swissquote, said it was notable that the British Retail Consortium’s inflation index for October showed the sharpest decline in food prices since the pandemic, which will be a “boost for the doves” on the Bank’s monetary policy committee concerned about rising shop prices.