By Naomi Rovnick, Alun John, and Dara Ranasinghe
LONDON (Reuters) – The pound has rebounded ahead of an expected landslide election victory for the opposition Labor Party, but the currency’s future depends on the next government convincing nervous investors that its plans to reform the sluggish economy are credible.
On a trade-weighted basis, sterling is back to levels not seen since the Brexit vote in 2016, with currency traders betting on a long era of currency volatility driven by turbulent politics under the ruling Conservative Party as it nears its end.
More than 20 economists and former government officials said that if Labor wins on July 4, a center-left government will need to maintain investor confidence while tackling economic challenges that the Conservatives have not solved.
UK public debt to GDP has reached a 63-year high and foreign direct investment has fallen for four of the last five quarters to the end of 2023. To avoid spending cuts, Labor will need to raise taxes or increase borrowing, according to the Institute for Fiscal Studies.
As investors evaluate the next government’s response to these problems, the balance of risks to the British pound is unbalanced because the currency has already priced in a strong Labor majority that would boost growth in Britain.
“The less confident political scenario will weaken the pound much more and make it more volatile,” said Costas Melas, a professor of finance at the University of Liverpool who studies the relationship between economic policy uncertainty and financial markets.
The Labor Party, led by Keir Starmer, is about 20 percentage points ahead of the ruling Conservative Party in the polls.
The Great British Peso
Sterling, once the world’s reserve currency, traded below the dollar average for the four decades before 2016, but at around $1.27 it has outperformed all its major peers this year.
It has fallen sharply from a record low of $1.03 in 2022 when former Conservative Prime Minister Liz Truss launched an underfunded mini-budget that led to a bond market collapse, increased debt costs and worsened inflation.
The pound’s volatile journey has prompted commentators to dub the pound “the Great British Peso”, with a resemblance to a risky emerging market.
Its volatility has fueled the UK economy, creating a negative feedback loop.
Melas’s research found that economic policy uncertainty in Britain since 2016 directly caused financial market pressures including increased exchange rate volatility which in turn caused the economy to grow less than it would have otherwise.
Analysts said a Labor government with predictable, market-backed policies could reverse this cycle.
“If Labor follows the rules of the game and gives some sense of fiscal responsibility, that’s a big boost,” said Guillermo Felice, global fixed income strategist at PGIM.
“The strength I’ve seen in sterling recently is ultimately about (expected) stability,” Morningstar strategist Michael Field said.
Financial markets expect similar interest rate cuts from the Bank of England and the European Central Bank this year.
But while the mini-budget debacle has shown that fiscal policy is as important to sterling as interest rates, Labour’s exact policies are not yet known.
The union this week criticized both Labor and the Conservatives for releasing pre-election statements which it said “hid and avoided” the big tax and borrowing issues, creating a “knowledge vacuum”.
Labor did not immediately respond to an email seeking comment on its plans and the pound.
Cut or spend?
Analysts expect the pound to rise to $1.2875 in 12 months on average, according to LSEG data. Some see the risks even further.
Labour, which has not been in government for 14 years, is keen to shed its previous association as a party of taxes and spending.
Simon Harvey, head of FX research at Monex Europe, said currency traders were bullish on sterling in the short term because the UK government’s finances gave Labor no chance to overspend.
But if UK economic growth improves over time, he said: “There is still a risk that Labor will swing too far to the left, so people want to see how this will continue over the long term, and investment managers may not like how this looks over five years.” Years”. “Years.”
Nikolai Markov, chief economist at Pictet Asset Management, advised Labor to pursue a massive investment scenario that would lead to inflation and negatively impact UK bond markets and the British pound.
Britain faces higher inflation than other rich countries in the G7, with annual price rises peaking at 11.1% in 2022. A 10% fall in the value of sterling would add 1.3 percentage points to UK consumer price inflation over two years, According to Oxford Economics calculations.
Starmer has drafted pledges to stimulate investment in housing and infrastructure, which mirror the policies of US President Joe Biden, over the very long term.
“It’s a version of Biden economics,” said Giles Wilkes, a fellow at the Institute for Government and former adviser to British Prime Minister Theresa May. “This will not involve worrying levels of money in the market.”
Roger Bootle, a former economic adviser to Britain’s finance minister in the 1990s, Kenneth Clarke, said Starmer’s finance chief Rachel Reeves would likely continue to “reduce spending.”
But TS Lombard’s head of macroeconomics and former Treasury chancellor Dario Perkins said that if Labour’s cuts further strain public services, angry voters could drift towards populist parties, dashing hopes of the UK rebuilding trade links with Europe.
(This story has been reworked to fix graphic link in paragraph 2)