Kavita Bisht
The British pound has surged in anticipation of a projected landslide victory for the opposition Labour Party. However, the currency’s future hinges on the new government convincing wary investors of its ability to effectively address the stagnant economy.
The UK’s public debt-to-GDP ratio is at a 63-year high, and foreign direct investment has decreased in four of the last five quarters up to the end of 2023. To avoid spending cuts, Labour will need to increase taxes or borrowing, as noted by the Institute for Fiscal Studies (IFS).
Investors will closely scrutinize the new government’s strategies to address these challenges. The risks for sterling are asymmetrical because the currency has already factored in a strong Labour majority that could boost Britain’s growth. A less stable political scenario could significantly weaken and increase the volatility of sterling, according to Costas Milas, a finance professor at Liverpool University.
Labour, led by Keir Starmer, holds a 20-percentage-point lead over the ruling Conservatives in recent polls. Once a global reserve currency, sterling is now trading below its per-dollar average of the four decades before 2016. However, at around $1.27, it has outperformed major peers this year. The pound has rebounded sharply from its record low of $1.03 in 2022, caused by former Conservative Prime Minister Liz Truss’s poorly funded mini-budget, which triggered a bond market rout, increased debt costs, and exacerbated inflation.
This volatility has led to the pound being nicknamed the “great British peso,” drawing comparisons to risky emerging markets. This instability has adversely affected the UK economy, creating a negative feedback loop. Milas’ research indicates that economic policy uncertainty in Britain since 2016 has directly caused financial market stress, including increased exchange rate volatility, which in turn has hindered economic growth. Analysts suggest that a Labour government with predictable, market-supported policies could reverse this cycle.
“If Labour follows a fiscally responsible playbook, it would greatly support sterling,” said Guillermo Felices, global strategist at PGIM Fixed Income. “The recent strength in sterling is ultimately about anticipated stability,” added Michael Field, a strategist at Morningstar.
Financial markets anticipate that the Bank of England and the European Central Bank will implement comparable rate cuts this year. However, Labour’s exact fiscal policies remain unclear. The IFS recently criticized both Labour and the Conservatives for their pre-election manifestos, which avoided addressing major tax and borrowing questions, creating a “knowledge vacuum.”
Analysts predict sterling will rise to $1.2875 in the next 12 months on average, according to LSEG data, though there are risks further out. Labour, out of power for 14 years, is eager to shed its image as a tax-and-spend party. Simon Harvey, head of FX research at Monex Europe, noted that currency traders are optimistic about sterling in the short term because UK government finances limit Labour’s ability to overspend.
However, if UK economic growth improves, there remains a risk that Labour could veer too far left, potentially unsettling long-term investors, Harvey warned. Pictet Asset Management’s senior economist Nikolay Markov suggested that Labour might pursue heavy investment, which could prove inflationary and negatively impact UK bond markets and sterling.
Britain has faced higher inflation than other G7 countries, with annual price rises peaking at 11.1% in 2022. Oxford Economics calculated that a 10% depreciation of sterling would add 1.3 percentage points to UK consumer price inflation over two years.
Starmer has proposed investment in housing and infrastructure, echoing U.S. President Joe Biden’s policies, but on a smaller scale. Giles Wilkes, an Institute for Government fellow and former adviser to Prime Minister Theresa May, described it as a budget version of Bidenomics.
Roger Bootle, a former economic adviser to 1990s UK finance minister Kenneth Clarke, believes Starmer’s finance chief, Rachel Reeves, will likely “keep spending tight.” However, Dario Perkins, head of macro at TS Lombard and former Treasury adviser, warned that if Labour cuts public services too much, disillusioned voters might turn to populist parties, dampening hopes of the UK rebuilding trade links with Europe.
