Pound gains as UK political turmoil and inflation risks weigh on sterling outlook

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Pound gains, UK turmoil & inflation

Highlights

Sterling climbs 0.4% to $1.337 after dropping as low as $1.3304, despite lingering political uncertainty and inflation concerns.
UK gilt yields surge to multi-year highs as investors fear potential government borrowing increases under a possible left-leaning successor to Keir Starmer.
Money markets now expect at least two Bank of England rate hikes this year, reversing earlier forecasts of two cuts before the Iran war in February.

Sterling rebound faces political and rate pressure

As reported by Reuters, the pound is rising 0.4% on the day to $1.337 after earlier slipping as much as 0.15% to $1.3304, its lowest level since April 8. The move comes as markets balance short-term support from higher expected UK interest rates against concerns about political instability and the wider inflation outlook.

Prime Minister Keir Starmer is under intense pressure to quit after poor local election results earlier in May. Heavy Labour losses in the May 7 elections trigger calls from nearly a quarter of his lawmakers for him to step down, while two rivals are openly competing to replace him, adding to investor unease over the government's fiscal direction.

Starmer says he remains focused on his duties as prime minister and on serving the country. But the political turmoil is contributing to a broader selloff in UK assets, with borrowing costs rising sharply.

Gilt market stress clouds UK asset appeal

UK gilt yields surge to multi-year highs last week as investors fret that a possible left-leaning successor to Starmer could favor higher government borrowing to support growth. That prospect is seen as a risk for Britain's already fragile public finances.

While higher yields often attract foreign capital, traders are treating the current rise differently because stagnant growth and the risk of a larger inflation shock are reducing the appeal of holding sterling. MUFG currency strategists say unfavorable domestic political developments are hitting at a difficult moment for the gilt market, which is also exposed to much higher inflation risk from the energy price shock.

MUFG says it favors selling the pound to buy the lower-yielding Swiss franc in the near term. Money markets show traders now expect the Bank of England to raise interest rates at least twice this year, a sharp shift from earlier expectations for about two cuts before the Iran war broke out in late February.

In our earlier GBP/USD outlook, we noted that Sterling was attempting a short-term bounce near $1.337 while still trading below key moving averages, keeping the broader bias cautious. The analysis highlighted how the UK’s heavy reliance on gilts and the Bank of England’s policy stance can quickly feed into government debt-servicing costs, making the pound especially sensitive to shifts in rates and fiscal expectations.

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