British pound faces renewed weakness despite earlier resilience amid political transition and fiscal uncertainty

The British pound has largely shrugged off another change of government and geopolitical shocks to outperform many of its peers this year, but the currency's recent weakness could be set to deepen.

Sterling has gained around 1.6% against the euro year-to-date, adding 2.8% against the Swiss franc, 4.9% against the Swedish krona and 1% against the Canadian dollar.

It is near-flat against the U.S. dollar over the same period and down 1.3% against the Japanese yen.

The resignation of Prime Minister Keir Starmer on July 20 left Britain facing its seventh leader in 10 years, with markets watching closely whether a new administration would hold to the "fiscal rules" repeatedly emphasized by former Finance Minister Rachel Reeves.

U.K. borrowing costs have risen under Starmer's quickly appointed successor Andy Burnham, also of the center-left Labour Party, but that has occurred in lockstep with a global government bond sell-off.

Matthew Ryan, head of market strategy at financial services firm Ebury, said that a "clean and orderly transition of power" had "removed a potential banana skin and eased the perceived political risk premium attached to the pound."

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In a Friday note, Ryan said sterling had been "the surprise outperformer" among the G10 group of wealthy nations over the past three months, tying this to an unexpectedly resilient U.K. economy.

Gross domestic product grew by 0.4% in the second quarter, following 0.6% expansion in the first quarter — one of the strongest performances among advanced economies. Sunny weather and excitement around the FIFA World Cup boosted consumer spending, while business activity remained surprisingly resilient despite the volatile geopolitical backdrop.

The pound also drew support at the start of the Iran conflict in April on outsized market expectations for a monetary policy response to inflation fears from the Bank of England, Jane Foley, senior FX strategist at Rabobank, told CNBC.

The U.K. is highly vulnerable to higher oil and gas costs, both of which have spiked this year, helping push headline inflation near 3%.

Sterling weakness ahead?

Despite the resurgence of price pressures, the Bank of England has held its key interest rate at 3.75% throughout this year.

Current market pricing suggests low odds of a rate hike at its September meeting. In contrast, there are high expectations for a hike by the European Central Bank on Wednesday and, increasingly, the Federal Reserve later this month.

Central bank rate hikes typically boost their home currency.

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Dovish messaging by the BOE on Sept. 17 would "further expose the pound" just before markets get anxious for the first annual budget announcement of Burnham's administration on Oct. 28, Foley of Rabobank noted.

New U.K. Finance Minister John Healey said in a Monday speech that he would remain committed to fiscal discipline, while targeting a more even distribution of economic growth around the country — in contrast to the concentration of growth in powerhouse London.

JP Morgan U.K. economist Allan Monks said his remarks suggested a cautious approach to tax and spending changes given the backdrop of higher borrowing costs. The budget is likely to retain a focus on devolution, greater public control of public services and more private sector partnerships, but contain little to change the macro outlook, Monks said in a note Monday.

Ebury's Matthew Ryan said the budget contained a high level of political risk, and was likely to contain "a combination of higher ancillary tax rates and an increase in debt issuance in order to fund Burnham's spending ambitions."

These could include changes to taxes on property purchases and local council duties, an introduction of a "mansion tax" and tighter pension and personal investment account relief, he said, adding that markets would be jumpy over anything that looked likely to dampen growth and squeeze the private sector, while simultaneously requiring more borrowing.