Political risks may check sterling’s rally

Although sterling has shot up by nearly 5% on a trade-weighted basis since the start of the year, there are several impediments to a further significant appreciation over the coming months. The strength of the US labour market suggests that interest rates there are likely to rise at a faster pace than currently anticipated by the market, supporting the dollar. And while the ECB has only just started its QE programme, its likely effects have probably already been discounted in the euro’s value. Meanwhile, the UK’s large current account deficit signals that sterling is vulnerable to a shift in overseas investors’ appetite for UK assets. May’s general election, which could result in a fragile coalition and lead to either a disruptive referendum on the UK’s EU membership or the higher taxation of profits and wealth, could prove to be a trigger for capital outflows. So while interest rate rises in the UK over the next couple of years should provide some support to the pound, the possibility of a sharp fall in sterling should not be ruled out.