Britain's pound has surged in anticipation of a potential landslide victory for the opposition Labour Party in the upcoming election. However, the currency's future hinges
on the new government's ability to convince wary investors that it has credible plans to revive a stagnant economy.
On a trade-weighted basis, sterling has returned to levels unseen since the 2016 Brexit vote, as currency traders are optimistic that the era of volatility under the ruling Conservative Party might be coming to an end.
If Labour secures a win on July 4, the left-of-centre government will need to maintain investors' confidence while addressing the economic challenges that have plagued the Conservatives, according to over 20 economists and former government officials.
Economic Challenges Ahead
The UK is grappling with a public debt-to-GDP ratio at a 63-year high and a decline in foreign direct investment over four of the last five quarters up to the end of 2023. To avoid spending cuts, Labour may need to raise taxes or increase borrowing, as suggested by the Institute for Fiscal Studies.
Investors will closely watch how the new government addresses these issues, with the balance of risks for sterling being skewed because the currency has already factored in a strong Labour majority to boost Britain’s growth.
"A less confident political scenario will weaken sterling significantly and increase its volatility," said Costas Milas, a finance professor at Liverpool University who studies the link between economic policy uncertainty and financial markets.
Led by Keir Starmer, Labour currently holds a 20-point lead over the ruling Conservatives in polls.
The "Great British Peso"
Sterling, once the world's reserve currency, is trading below its per-dollar average of the four decades before 2016. However, at around $1.27, it has outperformed all major peers this year. The currency rebounded sharply from its record low of $1.03 in 2022, a nadir reached after former Conservative Prime Minister Liz Truss's ill-fated mini-budget.
The pound's volatility has earned it the nickname "the great British peso," drawing parallels with risky emerging markets. This volatility has created a negative feedback loop in the UK economy, with economic policy uncertainty since 2016 directly causing financial market stress, which in turn hindered economic growth.
A Labour government with predictable, market-friendly policies could potentially reverse this cycle. "If Labour adheres to fiscal responsibility, that will be a significant support," said Guillermo Felices, a global strategist at PGIM Fixed Income.
Uncertain Policies
The recent strength of sterling is tied to anticipated stability, according to Morningstar strategist Michael Field. Money markets expect similar rate cuts from the Bank of England and the European Central Bank this year.
However, Labour's exact policies remain unclear. The Institute for Fiscal Studies recently criticized both Labour and the Conservatives for their pre-election manifestos, accusing them of "hiding and ducking" major tax and borrowing questions, leading to a "knowledge vacuum."
Labour did not immediately respond to requests for comments on its plans and the pound.
Future Prospects
Analysts forecast that sterling could rise to $1.2875 in the next 12 months on average, according to LSEG data, though there are risks further out. Labour, keen to shed its image as a tax-and-spend party, faces limited options for overspending due to the UK's financial situation.
Simon Harvey, head of FX research at Monex Europe, noted that short-term optimism for sterling is based on the assumption that Labour won't have room for excessive spending. However, if UK economic growth improves, there is a risk that Labour might shift too far to the left, potentially unsettling long-term investors.
Nikolay Markov, a senior economist at Pictet Asset Management, suggested that Labour might pursue heavy investment policies, which could prove inflationary and negatively impact UK bond markets and sterling.
Britain's inflation, which peaked at 11.1% in 2022, remains a concern. A 10% depreciation of sterling would add 1.3 percentage points to UK consumer price inflation over two years, according to Oxford Economics.
Starmer has proposed long-term investments in housing and infrastructure, similar to U.S. President Joe Biden’s policies. "It is a poundland version of Bidenomics," remarked Giles Wilkes, an Institute for Government fellow and former adviser to Prime Minister Theresa May. "It won't involve market-troubling levels of money."
Managing Expectations
Roger Bootle, a former economic adviser to 1990s UK finance minister Kenneth Clarke, believes Starmer’s finance chief, Rachel Reeves, would likely maintain tight spending controls. However, Dario Perkins, head of macro at TS Lombard and former Treasury adviser, warned that if Labour's spending cuts further strain public services, it could drive voters towards populist parties, dampening hopes of rebuilding trade links with Europe.