Pound Sterling Faces Another "Difficult" Year Warns UBS

Politics will be a potential headwind in May when Starmer's Labour Party is expected to lose significant ground in local elections. Picture by Simon Dawson / No 10 Downing Street.

Despite a strong start, the British pound faces a difficult year say analysts.

Pound sterling reached new three-month highs against both the dollar and the euro earlier this week and could build on these gains in the short term before familiar headwinds see it trend meaningfully lower.

This is the assessment of strategists at the UBS Chief Investment Office, who say the British pound's rise is partly a "post-fiscal budget rally."

Near-term Gains...

Gains, aided by rising global stock markets, see the pound to euro exchange rate reach a high of 1.1563 and the pound to dollar exchange rate print a new multi-week peak at 1.3567.

A vacuum of domestic data means the UK currency likely won't be bothered by any calendar events for the next two weeks, aiding positive technical momentum in delivering modest appreciation.

💸 The second half of January sees the data tap open, introducing the first real domestic triggers of volatility. "Inflation data released later in the month will be more important given the implications for the Bank of England’s monetary policy outlook," explains UBS.

"We expect inflation to fall - but only gradually - leaving scope for elevated policy rates and the potential for successful GBP carry trades," adds UBS.

The British pound's constructive start to 2026 can therefore extend a little further, but analysts still think it will record another down-year against many currencies.

... Familiar Headwinds

🚩 Politics: Sterling will be tested in the spring when Brits go to the ballot box to elect their local councillors.

Here, Prime Minister Keir Starmer is expected to preside over a Labour Party wipeout in council elections, posing the potential for challenges to his leadership. The worry is that Starmer and Chancellor Rachel Reeves are replaced by a more economically left-wing figure that risks upsetting the UK's public finances.

Starmer will likely survive any leadership challenges and politically induced GBP weakness should prove short-lived.

"We expect JPY, GBP, and LatAm to witness periods of underperformance around fiscal and electoral headlines," says Jayati Bharadwaj, FX analyst at TD Securities.

📊 The economy: It is in the slow lane. Some economists warn it will underperform expectations, prompting the Bank of England to lower interest rates further, resulting in currency weakness.

"The market will need to see firm evidence of a brightening UK economic outlook to shift the consensus forecast in favour of the pound," says Jane Foley, Senior FX Strategist at Rabobank, in a note released Tuesday.

"Although the financial market reaction to November's Budget was relatively muted, we expect markets to increasingly question the credibility of the package," says Edward Allenby, Senior UK Economist at Oxford Economics.

Reeves announced significant tax rises, with the hospitality sector facing significant tax increases from April, with the pub sector warning of mass closures. This will be particularly detrimental to the labour market, given the sector's importance as an employer.

📈 Public Finances: Although the budget seems to have calmed concerns about the immediate state of the public finances, it's clear the UK's public sector debt burden remains a vulnerability. If the UK fails to realise the tax receipts it expects while seeing its benefits bill mount, it will have to borrow more.

Oxford Economics explains that the uncertain impact on revenues of many of the narrower tax-raising measures is also a concern, as is "a lack of spending restraint, and the dearth of growth-enhancing policies."

The problem is that debt issuance across the developed world is rising, making it harder for the UK to attract investors. UK bond yields are already elevated relative to its peer economies, and a big risk for sterling in the year-ahead is a resurgence of investor concerns about the UK's debt trajectory.

➡️ Amidst these familiar headwinds, UBS says 2026 will be a difficult year for the pound.

"This is likely to leave GBP in a more difficult spot than in 2025. We expect a consolidation of GBPUSD around 1.36 and EURGBP to tick slightly higher toward 0.89 over time," says UBS.

EUR/GBP at 0.89 equates with a pound to euro exchange rate forecast of 1.12.