After experiencing its strongest year since 2017, the value of sterling relative to the dollar is unlikely to repeat itself due to the weakening economy and the unpredictable election.
It's easy to understand why investors rushed back to buy British pound after it fell to a record low just 16 months earlier: the economy performed better than expected, the Bank of England was forced to delay monetary easing longer than its peers due to sticky inflation, and expectations of an early rate cut by the US diminished the appeal of the dollar.
With a value of around $1.28, the pound gained nearly 6% versus the dollar in the previous year, placing it second only to the Swiss franc in terms of performance among major currencies.
It is also a long way from its record low of $1.0327, which was reached in 2022 after then-prime minister Liz Truss startled investors with her proposal for unfunded tax cuts.
Although this strengthens sterling into what is expected to be an election year, drivers of the rally are losing momentum.
First, interest rate differentials, which have a significant impact on the $7.5 trillion daily global currency market, are beginning to fade.
The belief that the BoE would trail the Federal Reserve and European Central Bank in loosening policy had helped to strengthen the pound, but the most recent economic data had thrown this theme into disarray, according to Jane Foley, the head of currency strategy of Rabobank.
The inflation of UK consumer prices fell sharply to 3.9% in November, and its gross domestic product was adjusted lower to reflect a 0.1% decline in the third quarter.
In the Group of Seven, Britain's recovery from the pandemic has been the second weakest, behind Germany, and it may already be in recession.
The data drove traders to move up their expectations for the first rate reduction by the BoE; as a result, markets are now fully pricing in a 25 basis point reduction as early as May, compared to August just a few weeks ago.
According to traditional opinion, sterling is a "risk currency" that moves in tandem with other assets of a similar nature, mainly stocks. Its most recent increases coincided with the ascent to two-year highs of MSCI's world stock index.
A further threat to the pound would be a global stock market reversal, given that valuations are getting a little stretched.
According to Dominic Bunning, the head of European currency research of HSBC, the rise in sterling from $1.20 in October to $1.27 in late November, was completely unjustified in terms of interest rate differentials.
It makes much more sense, obviously, when compared to equity markets, he said. Because of the economic downturn in Britain, he anticipates that sterling will weaken this year and may drop as much as 6% from its current levels, to around $1.20.
Talking about politics
The British election is another potential cause of instability. It is scheduled for January 2025, but polls favor the opposition Labour Party, so it is expected to happen this year.
According to Rabobank's Foley, the timing of the vote could have an effect on sterling because it could affect when the BoE cuts interest rates in an effort to avoid appearing to influence the nation's mood around election time.
According to local media, there might also be some caution in advance of a budget that is expected on March 6 and may include further tax cuts.
To be sure, not all predict sterling weakness in the near future; forecasters are far less in agreement now than they were a year ago due to the uncertainty surrounding the world economy.
For instance, Goldman Sachs predicts that in a year, the pound will reach $1.35 because of strong equities prices and more tranquil government bond markets.