EUR/GBP
During the first three quarters of 2025, sterling depreciated against the euro, despite having a favorable interest rate differential, due to the resilience of the eurozone and fiscal pressures and political uncertainty in the United Kingdom. Since then, this dynamic has partially reversed, with a moderate appreciation that has become more pronounced following the conflict in the Middle East, during which sterling has outperformed most major currencies, aside from the US dollar.
The British economy is in a delicate position: on the one hand, the labor market continues to deteriorate, with the unemployment rate close to pandemic-era highs; on the other, political instability is mounting, with Starmer posting the lowest approval rating of any prime minister in the past 50 years, and the two traditional parties at historically low levels of support, amid the rise of populist parties on both the left and the right.
With regard to monetary policy, the conflict in the Middle East has abruptly changed the outlook. The Bank of England had been on an accommodative path from relatively high interest rates, with inflation gradually approaching the 2% target. However, inflationary risks stemming from the conflict have triggered a shift toward a more restrictive stance: markets are pricing in between two and four rate hikes by the end of 2026. In such a scenario, and against a backdrop of high stagflation risk, there are doubts as to whether a more restrictive BoE would support sterling if the economic deterioration is too severe.
We expect, however, that already restrictive interest rates and fiscal policies that help contain inflation over the medium term (such as the Ofgem price cap) will increase the likelihood that the BoE does not raise interest rates (in contrast to the expected tightening by the ECB). This is reflected in the divergence between market-implied rates and consensus analyst forecasts, which point to a stable policy rate. In this case, sterling would also weaken. Therefore, under both scenarios, the outlook for sterling points to depreciation against the euro.