Sterling weakened against a firmer US dollar, sliding to a three-week trough on Wednesday, as market participants kept a close watch on escalating Middle East conflict and renewed selling pressure in the UK government bond market. This came as both Washington and Tehran reverted to a heightened state of war preparedness following their most intense exchanges in weeks.

UK bond yields surged to an 18-year high, piling additional strain on Chancellor John Healey ahead of his debut budget submission slated for October 28. The pound traded at $1.3482, down 0.25%, marking its weakest level since August 14. The dollar index touched a two-week peak, with investors rotating into the greenback as a safe-haven play on mounting worries over energy supply disruptions, while also weighing divergent monetary policy trajectories across major economies.

Healey is set to unveil his initial budget on October 28, having pledged to adhere to the borrowing rules left by his predecessor, Rachel Reeves. Matthew Ryan, head of market strategy at Ebury, noted: "Sterling's one-month implied volatility has slid to its lowest point in over twelve years, but we anticipate this level will form a near-term floor given the brewing anxiety ahead of the budget announcement." He added, "This rise in yields will directly eat into the government's fiscal headroom, thereby amplifying the risk of an autumn tax hike, and this doesn't even factor in any additional spending increases Healey appears likely to pursue."

The euro edged up 0.10% against the pound to 85.85 pence. The Bank of England's policy trajectory remains a backdrop in the market. Expectations are broadly set for the central bank to hold rates steady at 3.75% this month, while the market has already priced in a 25-basis-point hike by year-end. Sanjay Raja, chief UK economist at Deutsche Bank, while reiterating that his base case remains an unchanged rate, commented: "The combination of rising inflation, higher household inflation expectations, and a stabilizing labor market reduces the need to ease the policy stance. We believe the debate over whether rates remain sufficiently restrictive will intensify in the coming months."